BATS Settles Direct Edge Case with SEC

The penalty is the largest ever levied by the US equity market watchdog against an exchange operator, and relate to issues at Direct Edge prior to its acquisiton by BATS.

During its investigation, the SEC found that the EDGA and EDGX venues purported to offer a single price-sliding process for handling orders, when in fact three variations existed ─ hide not slide, price adjust, and single re-price.

One of the more controversial in this case is hide not slide, a mechanism whereby orders that would normally be cancelled due to crossing or locking the National Best Bid and Offer (NBBO) temporarily "slide" by one minimum price variation below the NBO, in the case of bids, and one above the NBB for offers.

Once the price adjusts, the order slides back to the original bid or offer, eliminating the chance of it crossing the NBBO outside of the preferred venue. The key difference between this and a limit order is that, due to the venue changing the timestamp on the order for each successive slide, it is non-displayed.

As earlier timestamps gain higher execution priority, those would then be transacted as soon as the shift occurred, rather than orders entered at the time it happened.

There are several reasons why firms, particularly high-frequency trading (HFT) shops, would want to transact at one venue over another. One is for liquidity reasons, where said liquidity may be sparser at one exchange over another in that particular stock, and so their position would possibly become exposed.

Another is due to the rebates that some exchanges, such as Direct Edge at the time, pay for liquidity provision under maker-taker rebates, while charging for simply buying at the NBBO without putting an offer in that someone later transacts at.

No Order-Type Issue
Furthermore, the SEC found, Direct Edge failed to properly explain the prices for order ranking, and when they would become executable.

"These exchanges did not properly describe in their rules how their order types were functioning," says Andrew Ceresney, director of the SEC's Division of Enforcement. "They also gave information about order types only to some members, including certain high-frequency trading firms that provided input about how the orders would operate. Exchanges must ensure that their order types are described accurately in their rules and communications to all members."

However, as BATS Global Markets notes, the SEC investigation took issue with disclosure concerns rather than the order type itself.

"With respect to Direct Edge, the SEC is taking an enforcement action against the legacy Direct Edge exchanges with respect to functionality that was implemented prior to the acquisition by BATS. We entered into a settlement agreement with the SEC, without admitting or denying the allegations, in order to put this matter behind us," the group says in a statement. "The SEC does not allege that there was anything inherently inappropriate about the order type functionality. Rather, the SEC alleged that the price sliding functionality was not completely and accurately disclosed in Direct Edge's rules."

A separate SEC investigation into similar concerns at BATS Global Markets was closed without enforcement action. The firm is holding a customer call at 11am today with CEO Joe Ratterman to discuss the proceedings, and says that provisions for the fine had already been factored in to its third-quarter financial statements.