Rosenblatt Securities recently published a critical review of “Flash Boys,” the Michael Lewis book that has sparked explosive and contentious debates on high-frequency trading. In a blog titled “Trading Talk,” Justin Schack, managing director at Rosenblatt, offers insights into the transformation and evolution of the US equity market structure since the late 1990s. He contends that the Order Protection Rule, rather than HFT front-running, explains why the traders in “Flash Boys” that attempted to buy large blocks of stock saw offers fade and prices move higher when they placed an order:
The Order Protection Rule, passed in 2007, aims to ensure that both institutional and retail investors get the best possible price for a given trade by comparing quotes on multiple exchanges. The rule caused market markers to quote their best prices on all exchanges even though they did not want to actually sell the total amount of shares offered across all the exchanges. Once an order was filled in one exchange, market makers canceled orders at that offer price on other exchanges. In this scenario there is no HFT front-running; but just like HFT front-running, traders will witness offers fade and prices increase.
The review also argues that decimalization of the US equity markets in 2001 caused tighter spreads between the bid and ask prices of a stock (because the minimum price movement went down to $0.01 from 1/16 of a dollar). HFT firms entered the picture and started making money on penny spreads by trading smaller sizes very frequently. The argument in “Trading Talk” is that not many institutional investors or Wall Street banks would be trying to execute block trades on lit markets in the world of decimalization and algorithmic trading of small quantities of stock since it would show their hands and cause market impact. Investors would certainly see offers fade and prices move higher if they attempted a block trade on lit markets.