The Small Cap Tick Pilot went into effect on October 3, 2016, and many of our subscribers have been asking how Luminex executions in Tick Pilot Securities have performed. Industry reviews and experiences regarding the Pilot are mixed, but for participants who regularly trade names in the Tick Pilot universe, the general sentiment has been negative in that sourcing ample liquidity has become even more challenging.
Executing any one of the approximately 1200 names in the three Test Groups at Luminex can improve overall execution quality, because, apart from the $0.05 requirement for submitting orders, our executions are not subject to certain provisions of the Pilot that have made trading stocks challenging, like Trade-At.
The Trade-At provision does not apply to Luminex, and when coupled with our negotiated transactions’ exception to the Order Protection Rule – Rule 611 under Reg NMS – the overall amount of signaling to the broader market is reduced, which in turn, aids in the prevention of sudden and drastic price movements that could occur when satisfying the rules’ obligations.
We discuss why trading Tick Pilot securities at Luminex may improve execution quality, and review some of our execution metrics since the program began on October 3, 2016.
- Higher rates of information leakage and the added difficulty with sourcing liquidity in Group 3 stocks are believed to emanate from the implementation of Trade-At.
- The Trade-At provision does not apply to Luminex trades, and therefore, reduces signaling to the broader market and improves overall execution quality. Luminex may execute stocks in all Pilot Groups, at any price increment, and when trading securities in Group 3, routing orders to protected market centers with displayed top-of-book interest is not required.
- We examined Luminex trades in Tick Pilot stocks from October 3, 2016 through March 21, 2017 and compared the execution prices to changes in the midpoint of the NBBO. Our results showed that across all Groups, on average, the execution price was between 0.38 and 0.48 basis points of the initial NBBO midpoint, and over the duration of the trade, the midpoints moved just 1.9 and 2.9 basis points, of which approximately 1.5 basis points is the result of stocks’ natural price movement.
- Luminex trades in Group 3 stocks have resulted in an average execution size of over 37,000 shares, and 72% of the trades were a “Top 5 Print” on the day the stock traded.
Industry-wide preliminary data shows Group 3 is a lot more challenging
Apart from the time and effort that went into implementing the program, the most notorious element of the Tick Pilot, and quite possibly the most contested, is the Trade-At Provision1 for Group 3.
Industry wide calls and published preliminary data regarding the Pilot have shown what many initially expected, such as a general increase in transaction costs and volatility, and wider spreads. In January 2017, Eric Noll from Convergex published an update on the Pilot and expressed particular concern for the level of information leakage associated with trading Group 3 stocks, especially for institutions. The update stated, “But the possibility that Test Group 3 stocks are more subject to information leakage generated by large institutional orders than the control group or Groups 1 and 2 may be driving up transaction costs.”
Additionally, Noll opined, “The “trade at” requirement has clearly shifted more volume to “lit” exchanges and simultaneously widened spreads and increased bid/ask size relative to the control group, Group 1 and Group 2. To us, that is a worrisome development. Why is Group 3 seeing greater volumes and spreads? Is it just a statistical anomaly, or are market participants able to see (and profit from) institutional order flow more easily?”
Higher rates of information leakage and the added difficulty with sourcing liquidity in Group 3 stocks are believed to emanate from the implementation of Trade-At. This makes sense. Trade At has led to a greater decline in overall dark trading in Group 3 because market centers and brokers are prevented from crossing stock at a Protected Bid or a Protected Offer, and, trading at a price other than the midpoint. Therefore, traders will not only trade more on-exchange, but also, cross the spread more often in order to compensate for the lack of dark liquidity.
Compared to Groups 1 and 2, Group 3 stocks have experienced higher rates of lit market activity, especially on inverted exchanges – venues that charge a fee for posting liquidity and pay a rebate for taking. Generally, higher rates of signaling are associated with inverted venues, largely due to the economic incentives for removing liquidity and because paying to post indicates a higher degree of trading urgency. Inverted venues have a tendency to attract highly sophisticated and informed participants, and “paying to post” improves their chances of reacting to current and future price moves by being first to interact with an incoming order. Therefore, the increased trading activity in lit markets, particularly for inverted venues, explains some of the concerns around greater information leakage and higher trading costs.
How does Luminex reduce the potential for information leakage, particularly in Group 3 stocks?
The Trade-At provision for Group 3 securities centers on the ability, or inability, for a Trading Center to execute a sell order at a Protected Bid or a buy order at a Protected Offer.
Let’s say 2 parties with the same limit price begin a negotiation in a Group 3 Pilot security, and during the negotiation process, the NBBO changes, which renders trading at the mid-point ineligible because it would violate the parties’ limit price; but trading at the near or far touch would satisfy both parties. The trader with the near side limit has two choices. Either decline to trade, and risk missing valuable liquidity, or, take out the displayed interest at protected prices and complete the trade. Liquidity is of paramount priority to institutions, and in stocks that are difficult to trade, traders would, more often than not, opt for the liquidity. However, in Tick Pilot names, trading centers may only display and rank orders in nickel increments, so clearing out the displayed interest at protected prices could exacerbate quote movement and generate unnecessary signaling.
Luminex negotiations, which account for over 90% of our transactions in Pilot and non-Pilot stocks, are not subject to Trade At. Negotiated trades qualify under the Pilot’s definition of a Derivatively Priced trade, and by definition, are not intended to price match a Protected Bid or Protected Offer, and thus, Trade-At does not apply. In other words, should the execution price2 of a Luminex negotiation in a Group 3 security, by chance, equal that of a Protected Bid or Protected Offer, Luminex may execute it at any price increment, and routing orders to protected market centers with displayed top-of-book interest is still not required. Furthermore, Luminex trades that automatically execute (non-negotiated) are also not subject to Trade-At because they, too, are not intended to price match a Protected Bid or Protected Offer.
Luminex may trade in increments of less than $0.05
Under the rules of the Pilot, Luminex trades may execute in trading increments of less than $0.05. Luminex trades are either derivatively priced, or they occur at the midpoint, and both trading types qualify as permitted exceptions to the $0.05 trading increment requirement. An outline of the Luminex order handling and execution procedures for the Tick Pilot is below.
Luminex executions versus the midpoint of the NBBO
We examined Luminex trades in Tick Pilot stocks from October 3, 2016 through March 21, 2017. We wanted to know, during the negotiation process, did the quote change, and if so, how did Luminex executions compare? The pricing methodology of a Luminex negotiation assigns a heavier weight to the midpoints earlier in the negotiation, a calculation we firmly believe treats participants fairly and prevents traders from falling prey to sudden and extreme price movements that might occur later in the process.
According to our results (chart below), on average, Luminex executions in all Groups occurred within just 0.5 basis points of the initial NBBO midpoint, and yet, the midpoints of those stocks, on average, during the negotiation time, moved 2.5 basis points. This means that, for negotiated trades, while the midpoint of the NBBO changed between the start and end of the negotiation window, the final execution price more closely resembled the midpoint when the negotiation began. For context, we looked at the stocks’ average movement at the same time of day for the last 30 days and found “natural movement” was roughly 1.5 bps. Rapid and frequent quote changes are commonplace in an electronic market driven by speed, and sometimes, inhibit traders’ ability to consummate trades that transact in a negotiated fashion versus others which execute instantaneously. Yet, back when the majority of negotiations were handled by human traders – “upstairs” – in the instances when the quote moved, the execution price that was usually deemed most fair, referenced the NBBO when the negotiation began.
Our most interesting finding? Luminex executions in Group 3
What we found most notable were our execution results for the stocks we traded in Group 3, which were even closer to the initial midpoint at just 0.3 basis points. Group 3 stocks have generally incurred more volatility relative to Groups 1 and 2, so our results could imply that Luminex is trading Group 3 stocks more effectively and incurring less impact from not having to access the lit markets in order to satisfy Trade-At. We realize the Pilot is still in its early stages, and it is too soon to draw any definitive conclusions, but we will continue to monitor and provide updates regarding our execution performance as the program continues.
The Order Protection Rule and Trade At go hand-in-hand
All Pilot stocks remain bound by the Order Protection Rule, which requires that brokers and venues ensure they do not “trade-through” the U.S. NBBO.
Luminex negotiated trades qualify as one of the 9 exceptions listed in Paragraph (b) of Rule 611 under Regulation NMS, or the “Order Protection Rule” or “Trade-through Rule”. Negotiations in Tick Pilot – and non-Tick Pilot – securities at Luminex are also Derivatively Priced, and thus, are exempt from Rule 611. Therefore, all negotiated transactions at Luminex may execute at, within, or outside3 the NBBO. Additionally, in the event the execution price falls outside of the U.S. NBBO, a “top-of-book sweep” is not required as part of executing the trade.
Luminex Order Book & Execution Metrics by Group
Data excludes executions from the Control Group and covers the period from October 1, 2016 through March 21, 2017
Execution metrics are an important component to approaching venue analysis. At Luminex, given the nature of our participants, unless otherwise noted, we calculate our order book metrics on an order-by-order and trade-by trade basis. We find this method provides a more accurate view of the order book in that orders and trades carry equal weights, and that prevents large share and/or notional values from improperly skewing the results.
- Symbols Traded are relatively even between Groups 1, 2, and 3
- Average Execution Size: Average Execution Size across all groups was over 37,000 shares
- Top 5 Print Percentage (Excluding Auctions): Over two-thirds of the trades in each of the Groups were a “Top 5 Print” on the day the trade occurred. Most notable though, is that the Top 5 Print Percentage for Group 3 stocks was 72%, the highest out of all Groups
Key Characteristics of the Tick Pilot
- Market Capitalization: Under $3B
- ADV: Under 1million shares
- Stock Price (Common Stocks only – no ETFs, no ADRs): Above $2
- Order Entry: Brokers and Trading Centers may only accept orders in $0.05 increments (excluding the Control Group)
- $0.05 Trading Increment: Groups 2 & 3
- Trade-At Requirement: Group 3 only
Luminex Order Handling & Execution Process in Tick Pilot Securities
Industry Resources and Data
SEC Plan to Implement a Tick Size Pilot Program – (Click here for full document)
STA Open Call: The Securities Traders Association has held two calls to discuss the Pilot’s preliminary results and experiences thus far. Documents from each call are available here:
November 29, 2016: Tick Size Pilot Data – Preliminary Results (Click here for presentation)
February 1, 2017: Tick Pilot Data – Part II (Click here for presentation)