CHAPTER 4
Introduction to the ECN Platforms and Order Routing
Before trainees were allowed to touch a single trading terminal, Liz handed out a booklet with the month's updated fee schedule for each of the ECNs, alternative destinations, and the NYSE floor routes.
At the time I trained under my branch of Swift Trade Securities, the pricing dynamics were relatively simple: Most destinations would pay you in the form of rebates if your order adds liquidity to the market through their system, and they would charge you a fee if your order removes liquidity from the market using their system. While these fees often changed from month to month (and still do in many cases), due to competition between the top exchanges and ECNs, the industry standard was in the vicinity of paying you a 0.0025 per share (2.50 per thousand shares traded) rebate to add liquidity and charging you a 0.0030 per share (3.00 per thousand shares traded) fee to remove liquidity. Since, by its very nature, every given transaction that occurs through any particular ECN platform would have involved an order that is adding liquidity being automatically matched with an order that removes liquidity, the ECN itself will always pocket the difference as a markup for providing its order matching service. In some rare cases, depending on the volume transacted by a firm through certain ECN platforms, some would also offer a rebate that may be up to the amount as large as the fee for liquidity removal, so that the ECN would essentially offer free services as a reward for high volume.
In the years since, some ECN platforms have also reversed the pricing scheme (charge for adding, pay rebates for removing), which would cause their displayed liquidity to be taken out of the market at any given price level, before the other ECN names would, whenever a price level is about to break on highly liquid stocks. This is an aspect of today's market dynamics that is constantly changing and may not last.
For instance, at one time in the recent past (as of this writing), the Direct Edge exchange's EDGA system implemented this inverted pricing scheme by paying a rebate for removing and charging a fee for adding. Meanwhile, the traditional model was implemented by Direct Edge's EDGX system as well as mainstay ECN systems like NASDAQ (NSDQ) and NYSE Arca (ARCA). If, for example, a highly liquid stock is presently quoted with a national best bid of 12.01 and a national best offer of 12.02 (12.01 by 12.02), then odds are all of these ECN systems and others will appear on both sides of the market. For instance, on the national best bid price at 12.01 (displayed buy limit orders) there may be 100,000 shares posted on ARCA; 150,000 shares posted on NSDQ; 90,000 shares on EDGX, and 30,000 shares on EDGA. Meanwhile, on the national best offer side (displayed sell limit orders), there may be 110,000 shares posted on ARCA; 101,000 shares posted on NSDQ; 50,000 shares on EDGX; and 25,000 shares on EDGA. On most direct market access platforms with access to the Level 2 quotes, you will see these names displayed next to each other, typically with the national best bid on the left side and the national best offer on the right side. When a group of large buyers aggressively buy at market (market buy orders, which by definition are liquidity removal orders as they always remove liquidity from the lowest available offer price, which is the displayed liquidity posted above in the form of sell limit orders on the national best offer price), odds are the first destination these buyers will hit (if they have any economic sense in their heads or their programming) would be the 25,000 shares on the offer posted on EDGA. Why? Because EDGA will pay the liquidity remover for taking these shares off the hands of the parties who posted the sell limit orders to it (and those who did so will be the ones charged for adding liquidity on the EDGA system, due to its inverse pricing scheme). If the buyer is not quite so economically adept (or if the buyer is a poorly programmed algorithm), he/she/it might hit the offers on ARCA, NSDQ, or EDGX instead. Of course, that makes absolutely no economic sense in this scenario as the buyer would voluntarily be paying a fee to remove liquidity from these venues when he/she/it could easily have gotten the same shares, at the same price, on the same stock, by simply removing the same amount of liquidity on EDGA instead.
Now, if you're caught up with this concept, you might be asking, “Why does anyone ever add liquidity on an inverted pricing ECN like EDGA then?” Simple: Your order is likely to be filled before everyone else's at the same price. Also, remember that the first wave of buying may not actually break the level. In fact, you might actually get your sell limit order (which in this hypothetical scenario is posted on the offer price via EDGA) filled at the national best offer right before the market actually absorbs the bid level and takes the price down a level to 12.00 by 12.01 (one penny down from 12.01 by 12.02). On highly liquid stocks, this is the typical behavior of the pseudo-randomness found in intraday price action as every party, even those who might buy or short sell upward of tens of thousands of shares at a time, all have different time horizons, strategies, and intentions and may not be in conflict with your strategy even if they may be directly on the opposite side of one side of your trade.
The inverted pricing scheme was essentially a marketing strategy to attract active market participants, such as high volume proprietary traders, to choose the venue over other destinations on the same market. As in many other types of markets, increased competition will always be to the benefit of the consumers. Traders of all kinds, large and small, are the target consumers of the services provided by the ECN platforms.
The names of these destinations are the ones shown, in shortened form, on the Level 2 quotes. There is also a code (a single letter) that, on most direct access trading platforms, is used to correspond to each of these market centers when a trade is reported (whether displayed or hidden) on the consolidated tape (Time & Sales window). There are exceptions where the software will translate these letter codes automatically to the full names (for example, “ARCA” will print rather than the letter P), although this is rare among prop trading firms' platforms.
While memorizing a lot of letters and strange names might be tedious to the majority of the human species, I found that the easiest way for me to identify each name with the letter on the Time & Sales was to research their background and form something of a character identity in my head, and then connect that story to the letter. You may or may not have similar story-based memorizing tendencies, but I'll include some of this material to help those of you who share this quirk.
Like everything else in the world of finance, the ECN world is a story of mergers and takeovers—and, of course, loads of competition.
Of the first generation of ECNs from the 1990s, there are two majors that have survived, in some recognizable form, to present day: the Island ECN (ISLD, alternately NSDQ for NASDAQ) and the Archipelago ECN (ARCA). (Due to the M&A activity over the years, these two are now officially branded as the NASDAQ ECN and NYSE Arca, respectively.)
ISLAND-NASDAQ MAIN ECN (“Q”)
Island is currently a historical component of the letter Q on most stocks (NASDAQ ECN). For the purposes of memorization, let's call them Q for being quick to the market in a number of ways. The current incarnation of Island is actually NASDAQ's main ECN platform, but the ECN that NASDAQ bought out in 2005 was actually the product of a merger between the original Island ECN and the Instinet ECN in 2002 to become INET. NASDAQ itself was the world's first electronic stock market, launched in 1971. It was in many ways the Island that started it all when it comes to purely electronic order matching systems on modern stock markets.
Memorization key: Island, Instinet, and NASDAQ combined to become today's incarnation of NASDAQ's main ECN, which is Q for being quick to the ECN market.
So when you see “12:02:59 12.50 100 Q” on a stock's tape in a typical prop firm's trading platform, it means a transaction took place at 12:02:59 at the price of 12.50 for 100 shares, and this transaction was matched on Q, the NASDAQ ECN. (There's another reason to continue to think of this ECN as Island. As of this writing, its parent company, NASDAQ OMX Group, owns a number of other ECN platforms including the former Boston and Philadelphia exchanges, which have separate letter designations and very different pricing schemes and features, and are now known as NASDAQ OMX BX and NASDAQ OMX PSX, each with unique advantages and disadvantages in their offered order types. So it's easier to think of the main NASDAQ ECN system as Island, which is the originator in many ways.)
Long before the NASDAQ takeover or the Instinet ECN merger, the original Island ECN revolutionized the electronic trading world in 1997 by offering the original maker-taker pricing model (it pioneered the offer to pay liquidity providers a rebate while charging liquidity removers a fee). At a time when stocks were still quoted in fractional pricing, rather than decimals as they are today, one of the main benefits of this pricing structure was to give day traders added incentive to provide liquidity on stocks with typically tight spreads.
ARCHIPELAGO ECN—NYSE ARCA (P)
Second into the market was the letter P. Shortly after Island ECN pioneered the maker-taker pricing model in the ECN space, Archipelago decided to join the party in 1997 and offer a free ECN service. In fact, the name Archipelago itself (for which Arca is a common short form) was chosen to imply that it would be superior since the dictionary definition of its name is “a group of islands.” In 2000, Archipelago merged with the Pacific Stock Exchange (P on the tape) to form the Archipelago Securities Exchange. It retained the PACX identifier for years to come (as it did when I started training at Swift), and even though it later became more common to designate it as ARCA on most platforms, the letter code typically remains displayed as P. It became a real threat to all the big players at the time: Island, the original NASDAQ system, and the old all-human NYSE of the time. By the time I was training at Swift, the days of free Arca were long gone; Arca had by then adopted the same maker-taker pricing model used by their competitors at Island ECN.
Following NASDAQ's purchase of INET in 2005, the NYSE Group followed suit with the acquisition of Archipelago Securities Exchange in 2006. The Arca ECN has since been known by the full name NYSE Arca, but continues to be designated P for reasons logical only to those who remember the origin of the platform. (As a side note, NYSE Arca is a name used only to signify that the Arca ECN is owned by the NYSE; it does not imply in any way that it replaces the human-specialist floor of the NYSE—it does not. The floor continues to operate as it always has—albeit with electronic devices for the human specialists to match orders with—while NYSE Arca operates as the NYSE's electronic competitor to NASDAQ's “formerly-known-as-Island” ECN. Transactions from the NYSE floor itself are typically designated as N on the tape of NYSE-listed securities; and are shown with the self-explanatory “NYSE” on most Level 2 quote displays.)
DIRECT EDGE DUAL EXCHANGES—EDGA (J) AND EDGX (K)
Originally founded in 1998 as the “Attain ECN” by All-Tech, a firm headed by SOES Bandit Harvey Houtkin, the dual exchange platform was rebranded as Direct Edge when it was acquired by Knight Capital Group. In March of 2010, Direct Edge received approval from the Securities Exchange Commission (SEC) to convert from an ECN into a licensed electronic stock exchange. In short, Direct Edge is now legally an exchange competing for your business with the household names like the NYSE and NASDAQ. Direct Edge, however, runs dual platforms commonly known as EDGX (pronounced “Edge X”) and EDGA (pronounced “Edge A”).
Direct Edge has been granted exchange status in the legal sense, but like the NASDAQ and many of the exchanges around the world today, there is no physical trading floor. Both Direct Edge systems are entirely electronic and its servers have been physically located at the Equinix NY4 data center in Secaucus, New Jersey, since late 2010.
The EDGX platform is essentially a direct competitor to Island and Arca. It charges a fee for removing liquidity and pays a rebate for adding liquidity to it. The difference, of course, is that EDGX typically offers better pricing to both sides (a smaller charge for removal and a larger rebate for adding) to aggressively compete for market share from the big mainstay ECN systems.
EDGA, on the other hand, was originally launched as a free ECN to attract volume and later adopted the inverse maker-taker pricing model: It paid a rebate for removing and charged a fee for adding. For most of its history, EDGA has retained the inverted pricing model and created a new market dynamic in which it would often be among the first venues to be hit when a price level is ready to break on highly liquid stocks. On less liquid stocks with low average daily volumes, it was relatively rare to see any trader or market maker) post visible bids or offers on it at all as there is rarely a need to (it would be equally as easy or hard to get filled using a venue that would pay such a party for adding liquidity so there was no reason to use it).
Since the summer of 2011, EDGA has simply become the deep discounted version of the traditional maker-taker pricing model. Gone is the inverted pricing scheme. Instead, EDGA now charges for removing and pays rebates for adding liquidity—just significantly lower fees on both sides.
What's plainly obvious is that EDGX often appears literally as “EDGX” on Level 2 quotes on most trading platforms; likewise, EDGA typically appears literally as “EDGA.” There are exceptions to this with some direct access trading software that may actually show them as Edge-A and DirectEdge or some other variation to differentiate them, but most platforms conform to the actual names. What's much more confusing, however, is when one attempts to identify prints on the consolidated tape: EDGA is designated as the letter J and EDGX is designated as K. The reason for this is likely simply because these were among the few consecutive letter codes available to Direct Edge for use on the consolidated tape at its launch.
BATS TRADING DUAL EXCHANGES—BZX (Z) AND BYX (Y)
Next up among today's top ECN platforms is BATS Trading, a Kansas City headquartered company founded in mid-2005. While its name on the typical Level 2 quote is as straightforward as it gets (BATS), it is shown on the tape as the letter Z. There's almost no logical explanation for this choice except for the fact that the letter B had already been taken by the Boston exchange at the time of the original BATS Trading ECN's launch.
Having stayed asleep (Zzz) somewhere far away from the financial capital of New York, BATS Trading aggressively marketed itself to day traders in 2005 with e-mail marketing campaigns and touted its maker-taker model, priced more aggressively than Island's offering at the time. As humble as can be, the name itself was originally an acronym for “Better Alternative Trading System.” In the years that followed, BATS gradually gained market share for its favorable pricing in the ECN world. Today, on highly liquid stocks, it's not uncommon to see displayed liquidity from BATS around the same size as NASDAQ's main ECN (the former Island) and Arca (the NYSE Arca ECN). It's also not uncommon to see as many, or more, Zs as Ps and Qs on many of the most liquid stocks' tapes.
Following Direct Edge's dual platform pricing (with one platform offering the traditional maker-taker model like Island and Arca and the other offering an alternative pricing structure), BATS cranked up the competition by acquiring the International Stock Exchange (ISE) and converting it to the BATS Y (or BYX) exchange with the tape designation Y. Like Direct Edge's EDGA (prior to summer 2011), BYX would offer an inverted maker-taker model in which a trader would receive a rebate for removing liquidity and the party who added liquidity would be charged a fee.
CBOE STOCK EXCHANGE—CBSX
In 2007, the Chicago Board Options Exchange (CBOE) launched the CBOE Stock Exchange (commonly called CBSX) in cooperation with four major market makers. While the electronic platform utilized by the CBSX is based on the same technology as its parent company's options exchange systems, it should be noted that this is not actually the CBOE system. The CBSX is a fully electronic equities exchange created to compete with the other ECN systems in the U.S. stock markets.
In July of 2011, the CBSX moved its servers from its original Chicago-based facilities to the Equinix NY4 data center in Secaucus, New Jersey—the same building where Direct Edge's servers are located as of this writing—to compete for business from the high-frequency trading industry.
This ECN often appears as either “CBOE” or “CBSX” on the Level 2 quotes, depending on your direct access trading platform. On the consolidated tape, it often appears with the unfortunate letter code W, most likely for the same reasons as Direct Edge platforms' letter codes (few other options were available, least of all one that actually makes any intuitive sense).
The pricing scheme on the CBSX was initially an inverse maker-taker pricing model (pays rebates for removing, charges fees for adding liquidity) to compete with EDGA and NQBX at the time. As of this writing, CBSX has changed to a flat fee pricing model with identical (but relatively low) fees for both liquidity removers and liquidity providers on its platform. Of course, this is subject to change, as the CBSX seems to have rethought its entire pricing model drastically at seemingly random times in the past.
NASDAQ OMX BX (NQBX)—FORMERLY BOSTON STOCK EXCHANGE
The NASDAQ OMX Group (parent company of the original NASDAQ electronic exchange) acquired the Boston Stock Exchange and decided to rebrand it with the excessively convoluted title NASDAQ OMX BX, as its official full-form name. For short, you will often see this ECN on a Level 2 quote as “NQBX” and it will show up on the consolidated tape as the refreshingly intuitive letter code of B.
For most of the past few years, NQBX is the NASDAQ OMX Group's answer to EDGA as it offers the inverted maker-taker pricing model. Whether this will continue or will change as its competitors have in recent years remains to be seen. In either case, its parent company will need to retain some unique feature on this system to justify its existence alongside their other ECN systems, which all operate on the same markets.
NASDAQ OMX PSX (NQPX)—FORMERLY PHILADELPHIA STOCK EXCHANGE
The other exchange acquired by the NASDAQ OMX Group and given a needlessly convoluted full-form name is the former Philadelphia Stock Exchange, now known as NASDAQ OMX PSX (or NQPX for short) under the NASDAQ empire.
Relaunched in 2010, three years after the initial acquisition, NQPX offers a very unique feature that differentiates it from all the other publicly displayed ECN venues in a way that's not just another pricing model copycat: NQPX offers price-size priority order matching rather than the traditional price-time priority.
On any other displayed ECN venues that exist as of this writing (in other words, on any of the other ECN names introduced up to this point), the traditional price-time priority dictates that orders are posted on a first-come, first-serve, basis. If Trader-X posts 5.000 shares on the offer on Arca, and then Trader-Y posts another 7,000 shares on the same level on Arca, Trader-X's shares will execute first when a liquidity remover comes along and buys from the offer on Arca. In this example, this is a particularly significant issue in a scenario where the subsequent buyer may be buying a total amount smaller than Trader-X's offer, so the worst case scenario of missed opportunity for Trader-Y is that a buyer buys less than 5,000 shares before the market moves down in favor of sellers or short sellers. Effectively, the traditional ECN's price-time priority model works like a lineup. The first liquidity adder in line will get filled first when a liquidity remover comes along with an aggressive removal (market order).
The unique feature of the NQPX system is that a price-size priority model is used instead. In the price-size priority model, a larger order will cut in line in front of any smaller orders. So if Trader-X posts 5,000 shares on the offer on NQPX and then Trader-Y posts 7,000 shares on the same offer level on NQPX, then Trader-Y will immediately cut in line in front of Trader-X simply because its order is larger. (If a buyer comes along, Trader-Y's order will be filled before any shares are filled from Trader-X's order despite the fact that Trader-X had posted his or her order earlier.)
This system will typically appear on the Level 2 quotes as either “NQPX” or “PHLX,” or some variation in between, depending on how up-to-date your software is with NASDAQ's branding. On the consolidated tape, prints from this ECN will show up with the unfortunate letter code of X. (Obviously, P had already been taken by Arca due to its Pacific Stock Exchange history.)
* * *
During my first week of training, I had taken notice of INET, ARCA, EDGA, EDGX, and BATS (the original one, currently BZX or Bats Z), which were all already active on most of the higher volume stocks that I was permitted to trade during the initial training period.
Aside from offering different pricing structures, each of the ECN systems also offered other options that are similar to the settings and variables that you might see after the question mark in a long URL for a scripted web page. For instance, when you send an order to NASDAQ (the former Island ECN), you can specify a strategy setting for the order.
Here are a couple of examples of routing strategies that the Island ECN could be instructed to execute (these particular ones still work the same way as of this writing):
To put things into perspective, and to bring to light how often a single order can bounce around between the different market centers' electronic systems before it ends up being executed and printed on the consolidated tape, consider these examples of the routing strategy settings offered by the Direct Edge dual platforms (EDGA and EDGX):
ROUC: Considered Direct Edge's cost-effective smart routing strategy, an order sent to EDGA or EDGX marked with the ROUC strategy setting will first be matched against the internal order book of the system it was sent to (for instance, if it was sent to EDGA, then EDGA will attempted to match the order against other orders in EDGA itself first). Assuming the order is not filled immediately, it will then attempt to match the order against non-displayed liquidity in dark pool systems. If it still cannot be matched, the order will be sent to Boston (NASDAQ OMX BX). In one last attempt to get the order filled outside of the Direct Edge systems, the order will then be routed to the NYSE floor. However, unlike an order such as NASDAQ's DOT D strategy, the order will not rest at the floor. Instead, if it cannot be matched immediately, the order returns to Direct Edge and will be posted on Direct Edge's own EDGX platform specifically (whether the initial order was sent to EDGA or EDGX).
The entire processes of these routing strategies are executed in tiny fractions of a second. Often, the Direct Edge AROUC strategy is a popular method used by some styles of traders to manually “stop out” of a trade (the “get the @#$! out key,” as the hotkey assigned to AROUC is often called). Despite the long description required to accurately portray the process performed by Direct Edge's computers when it receives this order type, no human trader will typically notice that hitting the hotkey associated with this routing strategy and sending it to Direct Edge's platform would cause this up-to-six-step process since the order will fulfill its duty in less than the blink of an eye.
Also notice that the current incarnations of most of these electronic order matching systems will, in one way or another, incorporate the ability to look for liquidity in dark pools. Whether this is available as part of a specific routing strategy or otherwise, there is typically a way for any trader on a direct access platform to look for liquidity in the nondisplayed markets used by hedge funds and large institutions to move large blocks with minimal market impact. In the next chapter, I cover the basics of dark pools, I learned during the first few months in the deep end of the markets.