Recent research analyzed the speed at which trades move through the marketplace, typically originating from a broker order in Secaucus, traveling at fiber-optic speeds to execute orders on exchanges, and subsequently triggering reactions at microwave speeds. Currently, the study is examining the typical flow of quote updates across the market.
Findings indicate that primary listing exchanges generally establish the new National Best Bid and Offer (NBBO) most frequently. While orders tend to arrive at most venues at a fairly steady rate, certain venues experience a rapid increase in quotes at the new NBBO within the initial millisecond. The implications of this phenomenon on market structure and routers remain an area of interest.
Listing Venues and NBBO Formation
The study examines who sets new NBBOs by utilizing venue timestamps across all exchanges, eliminating any reporting delays to the Securities Information Processor (SIP). It reveals that primary exchanges set the new NBBO a majority of the time, which aligns with their competitive need for company listings. Companies assess exchanges based on factors like consistent quotes and tight spreads that minimize their capital costs.
For instance, Nasdaq market makers set quotes for Nasdaq-listed stocks approximately 58% of the time, whereas all other exchanges collectively contribute to less than 43% of the NBBO improvements for Nasdaq stocks.
Chart 1: More than half of the new NBBO prices are set by the primary listing exchange.
Different Rates and Speeds of NBBO Adoption by Other Venues
It is observed that other venues frequently adopt or replicate the NBBO prices established by primary exchanges. Most exchanges display a consistent arrival of new orders over time. However, certain exceptions exist:
- Sharp Increases: LTSE and IEX display rapid copying of quotes within a millisecond.
- Quote Volume: IEX distinguishes itself, especially for Nasdaq-100 stocks, by copying the NBBO quotes more than any other exchange, despite some exchanges providing more liquidity.
- Breadth of Quotes: IEX and LTSE stand out by generating copy-quotes for a wide range of stocks, creating an impression of widespread liquidity.
Chart 2a: IEX sends orders copying NBBO quotes for liquid (Nasdaq-100) stocks.
Interestingly, the pattern remains consistent when examining less liquid stocks. Although the overall increase in quotes is minor with 3,300 companies considered, the data indicates IEX and LTSE have an even sharper increase in copying quotes for these less liquid stocks. However, a large number of quotes does not necessarily lead to trades.
Chart 2b: There is minimal interest in copying quotes for less liquid, smaller-cap stocks.
Market Structure Implications
The implications of these dynamics vary for different market participants. For brokers and traders, the reduced emphasis on speed facilitates achieving top-of-queue positions on specific venues, potentially increasing spread capture and profitability.
However, the resulting fragmentation incurs costs for brokers through more complex routing and connections, and it elevates opportunity costs for investors. Additionally, the system’s dilution of queue priority may undermine competitive quoting practices tied to actual trades.
Rewarding Competitive Quotes
The fragmentation of quoting negatively impacts market makers by diminishing spread capture profitability, a fundamental component of their business.
The regulated data economics in the U.S. contributes to inefficiencies. The SIP revenue allocation formula, designed to equally reward quotes and trades, inadvertently favors high quote volumes over those that lead to trades. This situation has led to some exchanges earning significant quote revenues with limited trading activities.
Chart 3: LTSE and IEX send numerous orders copying the NBBO quotes.
SIP quote revenues represent millions for certain exchanges, creating an artificial incentive that fosters fragmentation without enhancing market competitiveness or reducing investor costs.
Ensuring the NBBO Protects Investors and Issuers
The NBBO’s role in safeguarding investors and issuers receives broad agreement. Research indicates that narrow spreads lower capital costs and boost liquidity, enhancing the U.S. market’s appeal.
While debates over an affordable public NBBO persist, emphasis may be needed on ensuring equitable economic rewards for venues and traders setting those quotes, which could enhance market efficiency.
