Back to the Future: Exchanges That Price Other Things Don’t Price Their Own Things Right

The first post I wrote almost 14 years ago was about an electronic trading system (in Japan) being overwhelmed by a avalanche of orders. The main conclusions I drew were: (a) since communications capacity is costly, it is uneconomic to build so much capacity as to make such outages impossible, and (b) pricing of capacity is the best way to ensure that it is utilized efficiently.

What is old is new again. A few weeks ago the CME was strained by a deluge of message traffic in the Eurodollar futures market. The surge was in part the result of something only dimly–if that–grasped 14 years ago: algorithmic trading. More specifically, algorithmic trading combined with the order matching and confirmation protocols of the CME and Eurodollar markets. Eurodollar futures utilize a pro rata secondary priority rule in the absence of a “TOP” order, i.e., an order that improves the best bid or offer. Moreover, the biggest order at the inside market gets informed of executions slightly before smaller orders. This advantage (on the order of 10-20 millionths of a second) provides a valuable edge.

This institutional setup provided incentives for two algorithmic traders to attempt to get a slight edge in quote size. Thus, each would send a message to increase its size when the other had the edge, which induced the prior leader to send a message to increase its size to regain the lead, which induced the other to send a message to send a message to regain the lead . . . which continued until the maximum quote size was reached. This race for priority in the book led to a surge in message traffic which put stress on the CME system.

Matt Levine wondered why the two algos didn’t just keep their orders at the maximum size. My surmise is risk: the larger size you show, the greater the risk. Furthermore, if someone else improved the price and became the TOP order, size didn’t confer an edge, so it makes sense to cut size.

The CME has responded by announcing fines of $10,000, with the threat of cutting off a violator’s trading connection altogether, for violations of a message traffic threshold. This is a rough form of pricing, so why call it a fine? Why not just call it a non-linear message pricing schedule?

I guarantee that a variant on this story will recur. Because capacity is costly, exchanges don’t price it, and rules adopted for other reasons (e.g., priority rules intended to promote quoting in size) provide an incentive to use this unpriced resource.

As I argued years ago, it’s odd that institutions–exchanges–that specialize in providing the platform to allow the pricing of scarce resources don’t find a better way to price their own scarce platform resources.