Trillium wasn’t quote-stuffing

By Felix Salmon
September 14, 2010
Chris Nicholson is right, where Courtney Comstock and Marcy Gordon are wrong: the $2.26 million fine slapped on Trillium is not for quote-stuffing. Instead, it's for layering.

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Chris Nicholson is right, where Courtney Comstock and Marcy Gordon are wrong: the $2.26 million fine slapped on Trillium is not for quote-stuffing. Instead, it’s for layering.

The distinction is an important one. Quote-stuffing, if it exists, is a destructive attack on an entire stock market. Layering, by contrast, is relatively benign, and the only people who get damaged by it are high-frequency traders who are looking to sniff out where the market is going and place trades attempting to front-run that move.

What Trillium did is market manipulation, to be sure, and it deserves a fine. But it’s a bit of a stretch to paint this as the first battle in the war against high-frequency traders — not least because there isn’t actually anything particularly high-frequency about what Trillium was doing.

Yes, Finra does say that Trillium’s layering was an “improper high frequency trading strategy”. But fundamentally it was about misdirection, rather than speed.

Layering is a way of getting good execution on a trade you already know that you want to do: it’s not some kind of market arbitrage where you’re trying to make immediate profits in a fraction of a second. The profits calculated by Finra constitute the difference between the prices that Trillium got and the prices that it would have got if it hadn’t been moving the market: in other words, Trillium could easily have made a loss on the trades, while still making illicit profits in the eyes of Finra.

An example would probably help. Let’s say that XYZ stock is trading at a bid of $24.50 and an offer of $24.55. And let’s say that a trader at Trillium wants to sell XYZ stock. He could simply hit the bid, and receive $24.50. Or he could put in a sell order at $24.54, and hope that someone wanting to buy will take him out there. That would be a much better outcome, because not only does he get a better price, but he also counts as the liquidity provider, and so gets a small rebate from the stock exchange. On the other hand, there’s no guarantee that anybody will take him up on that offer.

But let’s say that he puts in a hidden offer at $24.54, in a dark pool. That means that the offer is there, but no one can see it. (This is perfectly legal, by the way.) Then comes the sneaky part: he puts in a large number of public and visible bids at prices like $24.48 and $24.47. He doesn’t actually want to buy XYZ stock at those prices: in fact, he doesn’t want to buy XYZ stock at all. But to other traders, looking at the public order book, it looks as though there’s a large amount of buying interest in XYZ. So they start putting in their own bids: at $24.51, $24.52, $24.53. They’re all trying to get in front of the big new buyer they see in the market.

And presto, when they bid $24.54, they find that hidden sell order from Trillium, which gets a very good price on its trade and gets to count as a liquidity provider. And as soon as that happens, all those fake bids at $24.48 and $24.47 suddenly disappear. But the victims are the people (or algorithms) who thought there was a naive trader posting public buy orders, and wanted to trade against that order. It’s hard to feel a lot of sympathy for them. As Kid Dynamite says,

There’s a big problem with Trillium’s strategy: it’s illegal. It’s called market manipulation, and they got bagged for it. Ironically, most of the same people who are/will be happy that Trillium is getting punished for this behavior would also be happy that the participants who Trillium was trying to fool got fooled. It’s been made quite clear that the Populace At Large does not like the trend of traders, be they high frequency (more so, lately, obviously) or low frequency, reacting to publicly displayed quotations by changing their own quotes. Or lifting bids / hitting offers in response to publicly displayed quotes. Those are the very traders Trillium was trying to (illegally) take advantage of.

And so it’s important to distinguish what Trillium was doing from quote-stuffing. Quote-stuffing is essentially a denial-of-service attack, aimed at trying to slow down a market in an environment where milliseconds matter.

With quote-stuffing, high-frequency traders enter an enormous number of bids and offers, significantly outside the current bid-offer spread, just to introduce a vast amount of noise into the quote feed. All that noise takes time (maybe just a few extra nanoseconds) for rival HFT shops to process, giving the quote stuffer a crucial time advantage.

The SEC is looking into whether quote-stuffing exists, and whether it’s a strategy that anybody has actually used to make money. Opinions differ on that front. But let’s not confuse the SEC investigation into quote-stuffing with the Finra fine on Trillium. They’re two very different things.

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