Reg NMS Price Protection and Cross-Exchange Arbitrage

# Profiting from price discrepancies between stock exchanges


# Profiting from price discrepancies between stock exchanges












Here is an interesting video by Nanex: http://www.youtube.com/watch?&v=rB5jJuMP84E

Perhaps some of you have already seen something similar. It is an animation of the order routing. It shows 1/2 second of trading activity in the stock Johnson & Johnson slowed down to a couple of minutes.

I'm a bit confused on how the "moving symbols" should be interpreted. Firstly I thought that it was the orders that are sent to the other exchanges due to "Smart order routing", in order to provide the trader with the best execution of his trade. However, the description of the video says:

> "Note how every exchange must process every quote from the others -- for proper trade through price protection".

This lead me to believe these are the quotes that are sent to the other exchanges.

The description of the video also says:

> "Watch High Frequency Traders (HFT) at the millisecond level jam thousands of quotes in the stock of Johnson and Johnson (JNJ) through our financial networks on May 2, 2013. Video shows 1/2 second of time. If any of the connections are not running perfectly, High Frequency Traders can profit from the price discrepancies that result. There is no economic justification for this abusive behavior"

Could someone give a more detailed explanation on how high frequency traders jam the networks to exploit these price discrepancies?

## Answer by chrisaycock (score 10, accepted)

https://quant.stackexchange.com/a/7986

The "price protection" refers to RegNMS in the US. A stock exchange that does not have the best price must route all order flow to the exchange that does. The SIP in the figure is a consolidated feed that lists the best price among all exchanges.

Consider this example: a broker sends a market order to buy JNJ to NYSE where the best offer is \$86.97. However, NYSE notices that NASDAQ has an offer of \$86.96. By law, NYSE must route the order to NASDAQ even though the broker hasn't specifically asked for it. This is intended to protect the broker's client by ensuring that he gets filled at the best price no matter what.

This has nothing to do with "smart order routing". SORT is a way for a broker to route to the exchange with (1) the best price, and (2) the lowest transaction cost. (This latter number is from the exchange's fee schedule.) SORT can give the broker and his client an improvement of tens of cents per one-hundred shares traded. That can really add-up for very large clients. But there is no RegNMS mandate regarding transaction costs; the US government's only concern is that the price of the stock is the best available.

Now, regarding NANEX's claims that HFTs are "jamming" quotes: NANEX often makes paranoid and disparaging remarks regarding automated market making. It is possible in theory for an HFT to arbitrage a bid from one exchange that crosses with an ask from another. The HFT will send an "intermarket sweep order" to alert the exchanges not to route the order. (By law, the HFT is taking responsibility for RegNMS; this alone should give you an idea of how few market participants are actually capable of doing this.)

Now, ask yourself this: Aside from the fact that arbitraging crossed markets is actually pretty rare, is it morally wrong for the HFT to perform this arb? Is this different from the ETF market maker that provides liquidity for retail investors by arbitraging the underlying product? Is it different from the options market maker who has determined his prices according to put-call parity?

My point is that "simple arbitrage" is not so simple. And it is actually a net benefit for the broader market. But a YouTube video like that will never go viral.