Mechanics behind Sub-Pennying

Trading Defenders envisions three ways in which a broker-dealer or algorithmic program can "sub-penny" your passive limit order:

Assume the same NBBO in all scenarios.

NBBO, security XYZ:

BidSizeAskSize
$24.95500      $25.00 500

Your passive limit sell order is part of the NBBO at $25.00.
A market order to buy your $25.00 passive limit order is entered by another market participant.

1st Method, Sub-pennying via Broker-dealer internalization:

The market order that is taking your passive $25.00 limit order, is filled directly by the broker-dealer receiving the market order.  This is called an In-House fill.  The order never makes it to the exchange.  The broker-dealer steps in front of your passive limit order and sells the stock at $24.9999 from their own inventory.    The broker-dealer can legally step in front of your passive order in this manner, as they are providing "price improvement" to the buyer.  The price improvement is nominal, and does not justify the costs to the unfilled seller, from the missed trading opportunity.

2nd Method, Sub-pennying by hiding in front of the NBBO via a dark pool:

The market order that is taking your passive $25.00 limit order, is routed via a smart router.  Smart routers check "dark pools" of liquidity for a better price.  A dark pool is an execution venue that provides liquidity but does not provide public quotations.  In other words, it is a place where a trader can place hidden orders.  Algorithmic programs can place hidden orders that automatically sub-penny the NBBO.  This can be easily done by pegging the order to the NBBO, with a sub-penny offset.

For example,

The NBBO from the above example is $24.95, and $25.00.  An algorithmic program can be created to peg a buy order to the NBBO bid with a +.0001 offset, and sent into a dark pool.  Similarly, the same program can be created to peg a sell short order to the NBBO ask with a -.0001 offset, and sent into a dark pool.  Even though the public NBBO is $24.95 - $25.00, the algorithm has a hidden buy order at $24.9501 and a hidden sell short order at $24.9999.  If the public bid were to move up to $24.96, the algorithmic program automatically adjusts it's bid to $24.9601.  In essence, they are always hiding in front of the NBBO.

The market order that was sent via the smart router searches out the better price and is executed at the hidden $24.9999 price.  Again, the displayed liquidity provider is not filled.

3rd method, Sub-Pennying via Flash Trading:

The market order that is taking your passive $25.00 limit order, is "flashed" by the exchange to the HFT firm's computer (see Flash Trading). This gives the HFT firm a chance to trade against the market order.  The HFT firm's computer strategically places a sell short order at $24.9999 to take the other side of the flashed market order.  The quote is not displayed, so this does not violate SEC Rule 612.  Your $25.00 sell order, the displayed liquidity, is once again left unfilled.


















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