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ANALYSIS: Allegations of abuse over how a stock trade is executed may soon bring a new black eye to Wall Street or amount to little more than another warning about high-frequency trading.
The numerous order types - the instructions that govern price and other variables in a trade - and their use by high-frequency traders have sparked a growing debate over the structure of the U.S. marketplace.
Order types can reach an estimated 2,000 variations as a fully electronic market and more than 50 trading venues have multiplied the possibilities of how, when and with whom to trade. And they have changed how buying or selling interest in the market is detected.
Using order types to outsmart other traders has become the latest skirmish in a battle over the merits of high-frequency trading. While the proliferation of new order types baffles many market participants and has sparked talk of abuse, little proof of manipulation has shown up so far.
The largest and most powerful traders in the market use order types to gain a more favorable position in the order book and the exchanges have helped their best clients achieve that edge, said Sal Arnuk, a co-founder of brokerage Themis Trading LLC in Chatham, New Jersey.
"My point is the exchanges are providing their largest customers by revenue and volume, guaranteed economics. If that's not a red flag, I don't know what is," he said.
For their part, officials at U.S. exchanges are adamant that new order types are transparent and fully disclosed.
Gary Katz, president of the International Securities Exchange, a leading U.S. options exchange, said complaints about poor disclosure are unwarranted as exchanges are required to make documentation on new order types available to everyone.
"This is a fully transparent mechanism," Katz said at a convention of the Security Traders Association in Washington last month.
Exchange officials deny they serve special interests, noting the Securities and Exchange Commission approves all new order types. The exchanges answer critics by saying some traders have figured out how order types can work to their advantage while other traders have failed to do their homework.
A source at the SEC said the most sophisticated exchange users go to great pains to figure order types out. Even if some may benefit certain participants more than others, "I don't know that there's necessarily fire there," the source said.
But critics say the confusion from order types allows only a few investors to profit from the changes.
"The pace at which order types are changing and morphing is faster than ever," said Chris Nagy, president of KOR Trading LLC, a consultant to exchanges and brokerages, pointing to a steady stream of regulatory filings for new order types whose complexity, he said, confounds even professional traders.
"Most industry experts can't keep up," said Nagy, a former managing director of order strategy at TD Ameritrade Holding Corp, whose job entailed tracking order types.
Themis Trading's Arnuk finds especially troubling so-called "hidden" order types that are non-routable, which means orders can be kept from going to another exchange to be executed at less favorable terms. Arnuk said such orders are abusive as the user can wait for a trading opportunity that better suits their needs.
Both Nagy and Arnuk called for a moratorium on order types, and Themis has urged the SEC to annul most order types and set up a panel to scrutinize any new proposals.
Exchange operator BATS Global Markets said in February that the SEC had sought information about the development, modification and use of order types, and its communications with certain market participants, including members that are affiliated with its stockholders and directors.
A moratorium would limit competition and would not be in the best interest of the U.S. market, said Chris Isaacson, chief operating officer at BATS, speaking at the securities traders convention.
New order types help create a more efficient market by allowing trading to occur in "different ways, in different time frames with different objectives," he said.
Traders can stipulate the time an order is in force, how much of an order will be held back in reserve, whether the price will be displayed or not and how it will be routed, in various combinations. BATS lists nine main order types on its website.
But, "if you count all those unique permutations you get to 2,000 and you create what can count as one, which is a limit order," he said.
Limit orders are among the most common order types. But one limit order, where the price is "hidden" or not always displayed, has been flagged by critics as suspect because its price can slide up or down as the market moves. While that move raises hackles, it can also improve an incoming order's price.
The SEC allowed hidden orders to prevent the bid, or what a buyer is willing to pay, and the asked, or the offer price, from locking, the market's term for when both quotes are the same.
In March 2004, when trading was slower and there was less volume, Nasdaq found that quotes locked or crossed - when the offer price is lower than the bid and vice versa - more than 500,000 times on average every day.
Few people outside of high-frequency traders understand hidden orders, said Lionel Mellul, a co-founder of Momentum Trading Partners LLC, a brokerage that closed in July.
"From my experience that type of order is acting like a ghost and that's the beauty of it, clients just can't detect them," Mellul said.
Haim Bodek, a former trader at UBS who founded a high-frequency options trading firm that was shut in 2011, believes traders have gained an unfair advantage through hidden orders. He outlined his concerns this week in an extensive critique on the Tabb Forum, a website dedicated to market issues.
Exchanges have not mandated the use of hidden orders, Bodek acknowledged, and he wrote: "Yes, speed matters -- but only if you know what order type to send and when to send it."
Bodek declined to comment when contacted by Reuters. Bodek's lawyer, Shayne Stevenson, a partner at Hagens Berman in Seattle, said Bodek has brought his complaints to the SEC.
"The only public comment we have is that we believe the evidence will show that the abusive properties of these order types were not disclosed by the exchanges and that financial institutions should be aware of these abuses," Stevenson said.
It's unclear how regulators will react to the allegations, which are directed at institutional investors. Most agree that for the retail investor, trading is cheap and efficient.
The SEC does not require a limit order to be displayed if a customer, because of a trading strategy, so wishes. But how an exchange discloses its order types is paramount to regulators, who insist the rules be coherent and adhered to.
"The statute doesn't say, 'We can't have complexity in the marketplace,'" said Gregg Berman, a senior adviser at the SEC. "It doesn't demand simplicity; it demands fairness, equitable treatment," Berman told a conference of the Securities Industry and Financial Markets Association in New York two weeks ago.