Market maker Citadel Securities, stock exchange IEX and the Securities and Exchange Commission each gave oral arguments Monday in a legal case that could have large implications for financial markets.
Last October, Citadel Securities sued the SEC, seeking to reverse the SEC's previous decision last August to approve IEX's D-Limit order type, arguing that this order type would hurt the overall market. The case was argued before the U.S. Court of Appeals Monday.
The D-Limit product is designed to stop high-frequency traders from taking advantage of other orders when market prices are changing.
While the intricacies of stock orders may at first glance seem obscure, they speak to a larger issue of who controls the U.S. capital market structure and who benefits from the ultra-fast trading that dominates financial markets: retail investors, stock exchanges or high-frequency traders? Similar debates are going on over the SEC's current review of payment for order flow and stock exchange rebates, which some have argued decrease competition and hurt pricing for investors.
The D-Limit product is designed for certain orders with so-called displayed prices — high-frequency traders often trade against these orders that are waiting to be filled. At certain times of the day, prices can start to move, and because trading systems are so fast, some high-frequency traders can trade in the one or two milliseconds before the overall market price — known as the National Best Bid and Offer — changes, in order to gain an advantage, IEX says. That's faster than the blink of an eye, IEX's attorney Catherine Stetson said Monday.
This is known as latency arbitrage, a trading strategy that high-frequency traders use to trade at fractions of a second before slower executed orders — and is estimated to cost other investors $5 billion a year, according to the U.K.'s Financial Conduct Authority.
IEX has also argued that latency arbitrage incentivizes traders to trade off on public exchanges or through non-displayed orders, which decreases overall market liquidity and transparency.
The D-Limit product uses data from exchanges to predict when the NBBO is "likely to change in the next two milliseconds," IEX says. If it predicts a bid for a stock will move lower for someone posting a bid, or higher for someone posting an offer, IEX will move the buy price a bit lower than the NBBO and the sell order a bit higher than the NBBO. These times average just five to 10 seconds of the entire trading day but make an outsized impact because a large volume of orders trading against displayed quotes come in these moments, IEX says.
Asset managers, brokers and other market makers such as Vanguard, Goldman Sachs, T. Rowe Price, Jefferies, XTX and Virtu Financial have all supported the D-Limit product.
"Adverse selection stemming from latency arbitrage can have a negative effect on the national market system because liquidity providers may be more inclined to provide less liquidity at wider spreads. The D-Limit order provides a potential solution to this problem," wrote Philip Berlinski, the co-COO of equities and global markets at Goldman Sachs, in a letter to the SEC last year.
In the hearing Monday, Citadel Securities argued that prices are not moving due to latency arbitrage but rather simply due to large blocks of stock which are regularly being traded, which move markets. "Large orders across multiple exchanges cause prices to move," Citadel Securities' attorney Jeffrey Wall said.
Citadel also argued Monday that IEX's D-Limit order type shouldn't have been approved by the SEC because it stops orders from immediate execution as required by law. "The regulation says, 'immediately and automatically executable.' And the whole point of this is they're slowing it down so that it's not immediate, and then instead of automatically executing, they're automatically repricing. They're doing the exact opposite of what the regulation says," Wall said.
The SEC countered Monday that IEX should be allowed to use the D-Limit because it is not that different from other ways that exchanges seek to make trading fair, such as changing the length of a cord to traders' servers in a co-location facility, in order to make the time required for an order to reach an exchange exactly the same.
IEX's attorney Stetson said Monday that the D-Limit order type is an attempt to stop predatory trading. "I think what [Citadel Securities] is seeking is what we would say is unfair access because they are seeking to exploit that tiny moment of time when a price is changing, before other people, other liquidity providers and liquidity takers are able to get there," Stetson said. "This is discrimination against a type of high-frequency trader that engages in predatory latency arbitrage."
The three judges had some pointed questions for the attorneys on both sides, questioning both IEX's right to limit "immediate" trades and Citadel's ability to intervene in stopping the D-Limit product. "You're the one who's trying to kind of regulate your way into a market victory," said U.S. Circuit Judge Justin Walker to Citadel's Wall.