SLOBs and CLOBs August 14, 2013 at 10:22 pm
The Streetwise Professor, reviewing Haim Bodek’s The Problem of HFT, makes an important point about true central limit order book markets (CLOB markets) vs. those where a poor simulacrum of a central limit order book (SLOB) is created via market linkages:
I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB. Price priority is for top of book only. Time priority (or other secondary priorities) are not enforced across trading venues. Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically. Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB.
Because it links multiple execution venues, the SLOB has many seams. And one thing we know is that traders traders look for and exploit seams like Tom Brady looks for and exploits the seams in a zone defense…Socializing order flows by requiring exchanges to route orders to other markets displaying better prices encourages competition, and seemingly avoids the problems posed by private CLOBs and utility CLOBs, but raises its own difficulties. Indeed, these are the problems that we are experiencing today, and which Bodek identifies… The trade off is therefore pretty stark: it’s a pick-your-poison kind of thing. Don’t socialize order flow and live with market power, or socialize order flow to facilitate competition, and grapple with the technological challenges of creating a virtual CLOB, and fighting the never ending battle against attempts to exploit the seams.
He’s right: there is no easy answer here. My predilection is towards socializing order flow but that does have consequences for the power of the exchange, and pushes you pretty strongly towards a mutual exchange model with wide participation in governance and strong regulation. If you think (as you reasonably might) that such models tend to slide towards dominance by the big users at the expense of the little guy, and that exchange competition is the answer to that (perhaps a more dubious proposition), then you have to live with the SLOB model and its exploitable inefficiencies.