IEX is proud to launch its D-Limit order type, which will be available for all symbols beginning October 1. D-Limit was approved in August by the SEC after a process of more than a year of vetting internally and with our Members, and after a long public comment period.
D-Limit is an optional tool that any of our members can use when posting displayed or non-displayed orders. It is designed to protect members from losses they are exposed to from trading strategies that seek to execute against resting orders when prices are unstable and likely to move against parties providing liquidity. Apart from the benefit to individual users, we hope and expect it will encourage more displayed liquidity, with benefits to price discovery and market efficiency.
The purpose of D-Limit is not to penalize some participants to benefit others, but instead to increase incentives for participants to display their trading interest and to provide opportunities for others to interact with that trading interest in ways that benefit both.
The Problem with Displayed Trading
Enhancements in electronic communications technology have vastly increased the speed of communicating order and trade messages. Some participants can acquire and take better advantage of the latest technology than others. This is inevitable, of course, but one result is that very fast data and technology can be used to anticipate imminent changes in the national best bid and offer (NBBO). Certain trading strategies are designed to trade against displayed quotes in the one or two milliseconds before the NBBO changes in a direction favorable to the parties using these strategies. One consequence is that participants that choose to display their trading interest are subject to substantial losses in the form of adverse price movements occurring immediately after their orders are executed. This “adverse selection” reduces participants’ incentive to provide displayed quotes. This reduced incentive, in turn, can harm overall market quality by reducing the level of price discovery and transparency in the market overall.
The SEC described the issue this way in its approval order:
“In those rare moments when market prices are in transition, a race condition exists between liquidity providers who want to reprice their on-exchange displayed liquidity and the liquidity takers who want to take before those updates can occur. This creates information asymmetries and can lead to other externalities, which can affect the willingness of many market participants to post displayed liquidity because it subjects their orders to adverse selection when prices move and they are not able to see or react as fast to those changing conditions. In turn, this race can have a meaningful effect on all market participants because it can incentivize investors to trade in the dark, either off exchange or through non-displayed exchange order types. The result is that a valuable source of liquidity may instead seek out dark non-exchange trading venues where the speed traders’ advantage is moot, but in doing so this liquidity is no longer displayed to and accessible by the market as a whole.”
A Simple, Targeted Solution
D-Limit is an optional order type, available to all our Members, that is narrowly tailored to protect orders using this option from the effects of latency arbitrage strategies.
Specifically, it uses the IEX CQI (for “Crumbling Quote Indicator”), which is simply an algorithm that uses real-time market data from multiple exchanges to predict when the NBBO is likely to change in the next two milliseconds. If the CQI predicts the best bid for a particular stock will move lower, in the case of a party displaying a bid, or higher for a party posting an offer, IEX will automatically reprice the buy order to one price increment less than the national best bid, and will reprice the sell order to one price increment higher than the national best offer. These two-millisecond time increments total on average just 5 to 10 seconds of the entire trading day, but the protection D-Limit offers can have an outsized impact, because of the large volume of orders to trade against displayed quotes that arrive in these very brief moments.
D-Limit orders will maintain their user-specified limit prices at all other times, and IEX will readjust D-Limit prices only in one direction. D-Limit prices will not be readjusted in the opposite direction if market-wide bid prices move higher, or if offer prices move lower.
Working to Create Better Trading Opportunities
D-Limit represents an effort to work in partnership with our members to give them a new trading choice, whether they are trading for their own account, as market makers, or on behalf of investor clients.
D-Limit will offer a direct benefit to parties who are willing to provide displayed quotes. We believe that it will also benefit brokers and investors who want to access quotes on IEX by increasing the amount of displayed liquidity available in the market, contributed by a more diverse pool of participants. As the SEC framed it, “D-Limit orders should benefit all market participants by incentivizing more firms to post limit orders and thereby contribute to liquidity that all market participants can access.”
This last point is critical. Markets are complex ecosystems with many different groups of interdependent participants, and each plays an important role. Exchanges sit at the center of the system for providing and accessing displayed liquidity and have a unique ability to give participants new ways and incentives to interact with each other in a mutually beneficial way. This type of innovation is the hallmark of our free market system. Like any innovation, its success depends on its ability to meet an unmet need, and our Members, by choosing when and how much to use the D-Limit order type, will determine its impact.