Hidden Advantage: Routing Orders Using Undisclosed Trading Data

Michael Friedman, Trillium

22 August 2014
Should brokerage firms be allowed to use customers hidden order flow to guide their smart order
routers?
A priest, a rabbi, and a stockbroker are fishing in a boat in the middle of a lake. The priest says, I left my
knife in the car, gets up, walks across the surface of the lake to his car, and returns. The rabbi says, Im
going to the restroom, gets up, walks across the surface of the lake to the restroom, and returns. The
stockbroker watches dumbfounded and decides to give it a shot. He steps out of the boat, falls into the water,
and screams for help. The priest looks at the rabbi and says, Should we let him drown or tell him where the
rocks are?
A similar story plays out every day in the U.S. equities markets. Brokerage firms route their customers orders
to the various trading venues using automated smart order routers that analyze various signals in real time to
predict which venue is most likely to fill a particular trade. While some of those signals are public information
for example, which exchange has posted visible bids and offers at relevant price levels other signals are
hidden and known only to the broker. Should smart order routers be allowed to know where the hidden rocks
are?
The SECs enforcement action against a Citigroup affiliate this month shed some light on this practice. Lava
Trading ran a smart order router called Colorbook. Colorbook analyzed numerous different data inputs in real
time to decide where to route its customers orders. After Lava Trading bought LavaFlow ECN, a semi-dark
off-exchange trading venue (ECNs publicly display their best bid and offer, but hide their less competitive
Level II bids and offers, as well as other orders affirmatively marked hidden), Colorbook began using the
hidden orders resting in LavaFlows matching engine as additional signals to guide its router. From March
2008 to March 2011, Colorbook executed more than 400 million shares using hidden LavaFlow orders to
guide its router. LavaFlow is now paying a $5 million fine for allowing this to happen.
[Related: Liquidity Without Leakage? The Flaw in Algo Trading]
Was anyone harmed by LavaFlows leaks? The Colorbook customers whose orders were filled clearly
benefitted, because their orders were matched sooner, and with a higher fill rate, than they would have been
otherwise. Bloombergs Matt Levine postulates that the counterparties whose hidden LavaFlow orders were
filled also benefitted, because they too were matched sooner and with greater success than otherwise, and the
news of their unfilled interestthe concealment of which was their primary reason to enter hidden orders in
the first placewas not shared beyond some automated matching tools.
Levine is correct that hidden LavaFlow orders are more likely to be filled by Colorbook orders when the latter
knows the former exist. But hidden LavaFlow orders may also be less likely to be filled by non-Colorbook
orders. Take for example Customer A, who posts on LavaFlow a hidden offer to sell 5,000 shares. Customer A
marks that order hidden in order to conceal his actual interest from the marketand thereby avoid pushing
prices downwarduntil Customer B happens to route a crossing bid to LavaFlow. But if Customer B is on the
same side of the market as Customer A, and tells Colorbook to sell 400 shares at the same price as Customer
A, Colorbook because it knows that there is already substantial selling interest at that price is able to route
Customer Bs offer more aggressively than it would in the absence of that knowledge. (It is not clear from the
SEC order whether Colorbook actually did this, but it did have the necessary inputs to do this). If Customer
Bs order is filled ahead of Customer As as a result of Colorbooks more aggressive routing, there is one less
interested counterparty for Customer A to match with, and Customer As fill rate will go down. This is real
harm, and the SEC was justified in imposing a real fine to deter it.
The LavaFlow case addressed hidden order data. But what about the more prevalent use of hidden execution
data? The existence of an executed trade in a dark pool is public information, but the identity of the dark pool
where the trade occurred is not. When a trade is executed in a dark pool, it is reported to the rest of the market
through a Trade Reporting Facility (TRF) with the general venue signifier D. The TRF feed does not
indicate which dark pool executed each D trade. But the brokers involved in each D trade receive
confirmation messages that do. Many brokers use that dark print location data as signals to guide their smart
order routers for the benefit of other customers. Thus, a broker who just obtained several fills for Customer A
on Dark Pool X is likely to also route Customer Bs next order to Dark Pool X, because Dark Pool X is now
hot on the order routers heat map of venues.
Is this just as bad as the LavaFlow case? Customer B is getting a free ride on information harvested by
Customer As risk taking, potentially to the detriment of Customer A (if Customer A is still trying to access
liquidity, it now must share with Customer B). But several considerations set heat mapping apart. First,
execution data isnt quite owned by customers the way unfilled order data is. It would be odd to tell a broker
he cannot use his experience with your trade to facilitate his next trade for another customer. That is what
brokers do, and that expertise is what customers pay them for. Perhaps for this reason, the order secrecy rules
violated in the LavaFlow case only apply to ATS operators, not to brokers generally.
Second, the imbalance of information between participants in a TRF trade and the rest of the market is purely
the result of the peculiarity of TRF reporting, and is not fundamental to the trading process. Traders will
always wish to conceal the true extent of their supply and demand, but future improvements to TRF reporting
are very likely to require the publication of venue identities for each dark pool trade.
Nevertheless, brokers using heat mapping routers would be well served to expressly warn their customers that
non-public information about their trades may be disclosed to and/or used for the benefit of other customers. If
you are going to tell them where the rocks are, youd better warn the rocks.
[Related: Reigniting the Order Type Debate: Haim Bodek Explains the Real Issues with Undocumented
Order Type Features]

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