IFor years, EX has campaigned against phantom quotes (bids and offers that disappear immediately when investors want to trade) and exchanges that generate SIP data revenue and “kickbacks” granted to liquidity providers for the publication of illuminated quotes on the NBBO.
So it was a bit of a surprise to see the IEX file for the SEC approval of their quote-protected D-Limit order type, as it was designed to quote Fade and get routers to miss out on liquidity they believed they were that they could get it.
It was also a surprise to see the SEC cleared this, especially just months after Cboe’s Speedbump (with no quote protection) was rejected.
As we see today, D-Limit has already changed market quality and incentives – possibly forever – in material ways that most pundits have predicted.
One of these things is not like the other
For an investor looking at how much liquidity there is on the NBBO these days, the IEX has gone up from 0.6% of the NBBO size to nearly 6% overnight, adding to the advertised liquidity.
But that does not mean that the market quality has improved. IEX’s own data shows that D-Limit has an average fulfillment of only 25%. Markets without a speedbump cannot disappear from incoming orders and should be almost 100% fulfilled.
It is important that the approval of D-limit not only created phantom liquidity, but also created a new economic platform that was previously viewed as bad for market quality and that the exchanges must take into account.
Price slide for market makers
The whole point of D-Limit is to enable providers to avoid disadvantageous choices. As IEX says on a blog dated March 18, 2021,delay on all orders … IEX allows time to (use) data from other exchanges and update our offers to reflect these changes … before trades are executed.”
Disadvantageous selection occurs when a trade causes quotes to tick down (on a bid or vice versa). As a result, the liquidity provider receives a filling at a worse price (bought higher) than at the “new” (lower) market prices (Figure 2).
In short, IEX’s formula takes pricing orders from other exchanges and copies them onto IEX. They also move their market makers’ orders based on updates from pricing markets based on their proprietary data feeds. This shifts the boundaries in front of orders on the way to the quotes that can be traded at these quoted prices (chart 1 and chart 2).
D-Limit adds virtual discounts
Of course, “negative selection” causes losses for market makers. Sticking to a fixed offer at the old (higher) price leads to a loss if the market maker has to hedge (sell) the new market (bid).
Discounts help offset these negative choices by paying liquidity providers for their fixed offers that fill them. We’ve seen how important discounts are when creating competitive illuminated markets.
Another way to offset an adverse selection is to avoid these trades entirely by having the price drop immediately after the market switch (but before anyone can trade on IEX). The D-Limit was developed by IEX for this purpose.
How similar the profitability of liquidity provision is can be seen in Figure 1. While discounts compensate for the negative selection of a market maker, D-Limit avoids these trades, whereby the market maker receives a “virtual” discount and roughly the same profitability.
Figure 1: From a supplier’s point of view, the profitability of discounts and D-Limit are similar – both reduce the net costs of a disadvantageous selection for suppliers
Other studies show that the market assesses the total cost of providing liquidity very carefully, combining less obvious opportunity costs with explicit costs such as trading fees and rebates. So we should expect the value of the IEX virtual discount to increase to around 30 miles, just like the discounts that come with fills on maker-taker exchanges. Of course, one of the complaints about maker-taker markets is that Costs for buyers of explicit withdrawal fees. With D-Limit, the cost is less obvious: it is the cost to buyers of missing trades.
How do you rate an offer that you cannot trade on?
One way is to look at all of the IEX quotes at the NBBO and assume that the takers have paid the new spread for the quotes that slide on them. On that basis, we estimate that fading the IEX-D limit will add $ 57 million per year to the cost to consumers (annualized data for October 2020).
Diagram 2: From the point of view of the customer, take fees and D-Limit for both cost customers more than the illuminated offer that is being advertised
Just like real discounts, IEX’s virtual discounts for illuminated deals drew more market makers to their NBBO. The data shows that NBBO-compliant IEX quotes improved almost instantly from less than 5% before the D-Limit to more than 50% now.
This improvement in citation is important because it means …
IEX is all-in for data income
We talked about it recently how the SIP pays for the exchange For your data, both the time share and the fictitious size of the NBBO for the offer proceeds count. The “puzzle masters” knew all of this clearly when they filed for a D-Limit proprietary offer with the SEC, as this ensured that offers for SIP quote proceeds would be counted 99.9% of the time, even if they did overestimate actual liquidity available to customers.
SIP data shows that IEX has significantly increased its data revenue from these offerings. Based on the SIP reports for the fourth quarter of 2020, IEX is expected to earn more than $ 16 million per year in additional offering revenue thanks to D-Limit. This far exceeds the cost of proprietary data for IEX.
Interestingly, they are only on track to grow trading sales by $ 2 million a year.
Figure 3: IEX is already receiving $ 16 million a year in additional data revenue from D-Limit
The gap between quoting and trading revenue also shows how well the quotes lit by IEX fade away at the moment of actual trades.
Before the D-Limit, the IEX quote earnings were 23% of their total SIP earnings. With D-Limit, IEX will generate 69% of its SIP revenue from quotes, although most of its trading is still made up of hidden orders (Figure 4).
Other data also confirms that IEX quotes will fade before they can be traded.
After the D limit, IEX liquidity is still largely hidden. In fact, touch performance has only increased a small percentage. Increased trading revenues are likely to be achieved through hidden orders taken by buyers that refer to the protected D-Limit NBBO. Some may call this a “bait and switch,” especially since hidden orders also earn the IEX much higher trades of 9 miles per side.
Figure 4: Despite all the quotes and quote income, the IEX volume is still largely hidden
Shakedown in DC is complete
For most industry experts, this is no surprise. However, the effects are far-reaching.
The SEC’s approval of D-Limit with Protected Offering status shows that the target posts for acceptable market quality and incentives have shifted significantly. Phantom quotes are fine. Virtual discounts are accepted regardless of the cost to customers. It’s okay for some exchanges to artificially delay sending some NBBO prices to the SIP – in fact, the NBBO doesn’t always have to be available to everyone.
Instead of making the markets more efficient, regulators have introduced more freeriding. Graduated prices based on price determinations from other exchanges are permitted.
Now market makers, who set public prices on illuminated exchanges, are helping an independent exchange generate millions in SIP and trading revenues.
