Clean Sweep: Informed Trading Through Intermarket Sweep Orders

Sugato Chakravarty Pankaj Jain James Upson Robert Wood

What is an ISO?
Exempt from Order Protection Rule, Rule 611.
ISO can trade through best price.

Allows trade initiator to designate market for trade execution. ISO orders will execute immediate on the designated exchange. Allows for parallel processing of demand.

Non-ISO Orders
Governed by Order Protection Rule. Routed to the market center with the best price. Orders are process in sequence. Orders should execute at the best price available in the market.

ISO vs. Non-ISO processing

Market Centers Non-ISO ISO

NBBO NBBO

D Parallel Order Processing

Motivation

Stealth Trading
Barkley and Warner (1993)
Medium sized trades drive returns.

Chakravarty (2001)
Medium sized institutional trades drive returns.

Anand and Chakravarty (2007)

Medium sized options trades have high information share.

Market Stability
Glosten (1994)
Open limit order book markets are robust to competition

Back and Baruch (2007)

Other market types mimic open limit order book Informed and Liquidity traders work orders (small trades).

Research Questions
Do both informed and uninformed work orders in the sense of Back and Baruch? Are ISO orders dominated by informed or uninformed traders? Are medium sized orders still the driver of returns and information in the post Reg NMS market?

Main Findings
Back and Baruch worked order equilibrium dominates market.
Average order size of ISO and non-ISO orders is 178.8 and 217.6 shares respectively. 89% of ISO orders and 86% of non-ISO orders are less than 500 shares. Distribution of ISO and non-ISO orders closely match.

Main Findings
ISO orders are dominated by informed traders.
ISO orders have higher effective spreads but lower realized spreads, relative to non-ISO orders. ISO orders have higher information share, relative to ISO volume, even with smaller trade size.

ISO order Info Share is increasing in market volatility.

Data
Trade, quote, and NBBO data from Daily Trade and Quote database (DTAQ). Market capitalization and common stock identification from CRSP.

Sample Filters
Trade on first and last day of sample, August 20, 2007-May 30, 2008. 201 trading days. Common between DTAQ and CRSP datasets. Close price on December 31, 2007 between $10 and $1000. Common stock (CRSP code 10 and 11).

Sample Selection
Rank companies by market cap
Large, Medium, and Small.

Select top 40 companies from each group.

Total of 120 companies.

Sample Descriptive Statistics

Number of firms Average market capitalization (billions) Number of trades (millions) Percent ISO trades Share volume (billions) Percent ISO volume

Full Sample by firm size

120

50.30

515.20

46%

147.47

41%

Large
Medium Small

40
40 40

148.55
1.89 0.45

466.23
39.58 9.39

47%
44% 50%

138.29
7.55 1.63

42%
40% 45%

by listing exchange
NYSE NASDAQ 72 48 67.13 25.05 368.16 147.04 44% 52% 97.59 49.89 38% 48%

Trade Size and Distribution of ISO and non-ISO orders

Evidence of a pooling worked order equilibrium

Trade Size Analysis

NonISO Median NBBO Quoted Depth 13 63 12 7

Sample

ISO

Diff

t-value

Full Sample Large Stocks Medium Stocks Small Stocks

178.8 235.5 157.3 143.6

217.6 292.4 187.5 172.9

-38.8 -56.9 -30.2 -29.2

-47.0 -32.9 -39.8 -30.8

Trade Size Distribution (Full Sample)

Trade Size ISO Trades (millions) 213.16 17.13 8.80 0.35 0.13 Percent Non-ISO Trades (millions) 237.44 24.23 13.52 0.64 0.26 Percent

<500 501-1,000 1,001-5,000 5,001-10,000 10,000+

89.0% 7.2% 3.7% 0.1% 0.1%

86.0% 8.8% 4.9% 0.2% 0.1%

Total

239.57

100.0%

276.10

100.0%

Distribution by Firm Size

Trade Size

<500
Large Stock non-ISO ISO 85.1% 88.3%

501-1,000

1,001-5,000

5,001-10,000

10,000+

9.3% 7.6%

5.2% 3.9%

0.2% 0.2%

0.1% 0.1%

Medium Stock non-ISO ISO Small Stock non-ISO ISO 94.7% 96.7% 3.4% 2.4% 1.7% 0.9% 0.1% 0.0% 0.1% 0.0% 93.9% 95.5% 4.2% 3.3% 1.7% 1.1% 0.1% 0.0% 0.1% 0.0%

Trade Size Interpretation

Small trade size supports pooling worked order equilibrium of Back and Baruch. Smaller trade size of ISO orders indicates low information (Barkley Warner (1993), Easley OHara (1987)).

Are ISOs Informed?

Uninformed
ISOs are de facto Preference Order Flow. ISO are small trades <500 shares.

Informed
Parallel order processing Exemption for institutional traders

Preferencing Review
Chordia and Subrahmanyam (1995)
Preferencing focus on of NYSE exchanges

Chung, Chuwonganant, McCormick(2004)

62.5% of volume on NASDAQ preferenced

He, Odders-White, Ready(2006)

Define Preference Measure (PM) as ratio of realized to effective spread. Show PM is higher on NASDAQ (more preference order flow).

Sweep order by Exchange

Market Exchange National ADF International Chicago NYSE Share 1.3% 22.6% 1.3% 0.3% 44.5% Full Sample Trades 70.4% 29.3% 52.8% 63.9% 20.9% Vol 71.7% 21.9% 52.4% 58.4% 23.5%

Pacific/Arca
NASDAQ Phil CBOE

14.8%
33.5% 0.2% 0.2%

52.8%
62.7% 42.0% 43.9%

53.5%
63.6% 52.0% 43.1%

Spread Analysis
Spread Effective Spread Sweep 1.11 Non-Sweep 1.01 Diff 0.10 t-value 8.97

Realized Spread*
Preferencing Measure

0.06
0.14

0.18
0.24

-0.12
-0.11

-8.79
-7.19

*Realized spread based on NBBO midpoint at +5 minutes

Spread Analysis by Firm Size

Spread
Large Stocks Effective Spread Realized Spread Preferencing Measure Medium Stocks Effective Spread Realized Spread Preferencing Measure Small Stocks

Sweep
0.71 0.23 0.39
1.01 0.13 0.12

Non-Sweep
0.68 0.33 0.49
0.91 0.21 0.23

Diff
0.03 -0.09 -0.10
0.10 -0.08 -0.11

t-value
2.93 -5.58 -3.97
11.96 -4.87 -6.56

Effective Spread
Realized Spread Preferencing Measure

1.61
-0.17 -0.10

1.44
0.00 0.01

0.17
-0.17 -0.11

6.58
-7.13 -6.75

Spread Analysis by Listing Exchange

Spread
NYSE Effective Spread Realized Spread Preferencing Measure 0.86 0.24 0.33 0.79 0.29 0.41 0.07 -0.05 -0.08 8.30 -2.89 -3.46

Sweep

Non-Sweep

Diff

t-value

NASDAQ
Effective Spread Realized Spread Preferencing Measure 1.48 -0.20 -0.15 1.33 0.02 0.00 0.15 -0.21 -0.15 6.17 -10.33 -10.35

Spread Interpretation
ISO not dominated by Preferencing.
Lower PM measure. Lower or negative realized spread.

ISO as informed trading.

Higher effective spread but lower realized spread.

Information Share
Hasbrouck (1995)
Introduction of information share Method. Finds Info Share of regional markets lower than market share.

Hasbrouck (2003)
Compares Info Share of ETF, Futures, and Indexes Finds price information share dominated by Futures

Anand and Chakravarty (2007)

Investigate Info Share of small, medium, and large trades in options market. Finds Info Share is dominated by medium trades.

Operational Details
Use two price channels, ISO and non-ISO Use last price, ISO or non-ISO, each second. Point estimate based average of Upper and Lower. Information shares estimated for each stock day.

Large Stock Info Share

Panel A: Large Stocks
0.8 0.75 0.7
Information Share

Non-ISO Information Share ISO Information Share Percent ISO Volume

80% 75% 70%

Percent ISO Volume

0.65 0.6 0.55 0.5 0.45 0.4 0.35 0.3

08 20

65% 60% 55% 50% 45% 40% 35% 30%

09 18

10 16

11 13

12 08

01 07

02 05

03 05

04 03

05 01

20 07

20 07

20 07

20 07

20 07

20 08

20 08

20 08

20 08

20 08

Date

20 08

05 30

Information Share

20 07

0.35 0.4 0.5 0.6 0.7 0.8

0.45

0.55

0.65

0.75

0.3

08 20

20 07 09 18

20 07 10 16

20 07 11 13

20 07 12 08

20 08 01 07

Panel B: Medium Stock

Medium Stock Info Share

Date
20 08 02 05 20 08 03 05 20 08 04 03 20 08 05 01 20 08 05 30

30%

35%

40%

45%

Percent ISO Volume

50%

55%

60%

65%

70%

75%

80%

Information Share

20 07

0.35 0.4 0.5 0.6 0.7 0.8

0.45

0.55

0.65

0.75

0.3

08 20

20 07 09 18

20 07 10 16

20 07 11 13

20 07 12 08

20 08 01 07

Panel C: Small Stocks

Small Stock Info Share

Date
20 08 02 05 20 08 03 05 20 08 04 03 20 08 05 01 20 08 05 30

30%

35%

40%

45%

Percent ISO Volume

50%

55%

60%

65%

70%

75%

80%

Formal Evaluation
Mean Info Share Mean ISO Paired Volume Diff (Info Share Shr) Mean Mean non-ISO ISO Trade Trade Size Size Paired Diff (Trd Size)

Market Capitalization Large Stocks Medium Stocks Small Stocks 0.508 0.399 0.487 0.402 0.380 0.461 0.106* 0.020* 0.026* 261.7 157.6 141.6 355.4 199.7 182.4 -93.7* -42.0* -40.8*

Listing Exchange
NYSE Listed NASDAQ Listed 0.399 0.564 0.360 0.496 0.039* 0.068* 196.4 172.8 252.0 236.6 -55.5* -63.8*

*Difference is statistically significant at the 1% level

Information Share Interpretation

ISO trades in Large stocks have disproportionate impact on price discovery. ISO price discovery impact is larger, even with significantly smaller trade size. While statistically significant, ISO impact for Medium and Small companies is less clear.

However, the paired t-test assumes equal rates of information production for all size categories.

Information Share Regression

We estimate:

ISOinfoit MpStd it LnCapi Listi it

Where: ISOinfoit is the Information Share for stock i on day t. is the intercept

MpStdit is the Mid-point volatility

LnCapi is the market cap and Listi is 1 for NASDAQ listed stocks and 0 else wise.

Regression Results
Parameter Intercept Full Sample Estimate -0.0373 (-5.07) MpStd 0.0118 Large Stocks 0.2221 (4.97) 0.0188 Medium Stocks -1.4843 (-1.23) 0.0763 Small Stocks -2.1501 (-1.30) 0.0455

(4.85)
LnMcap 0.0267 (61.41) List 0.2187 (89.62) Adj R2 F-Statistic N 0.268 2,947 24,102

(7.92)
0.0138 (5.77) 0.1229 (41.94) 0.182 597 8,036

(5.04)
0.1239 (1.49) 0.2959 (69.01) 0.400 1,786 8,034

(3.42)
0.1895 (1.49) 0.2084 (39.55) 0.150 473 8,032

Trade Through Analysis

Large number of ISO trade throughs violate price linkage requirement of Information Share analysis. Foucault and Menkveld (2008).
Find large trade through rates (75%) negate smart routing system. This impacts non-ISO orders.

Very low trade through rate negates need for ISO order exemption.

Trade through analysis based on flickering quotes rule.

Exchange can use least aggressive NBBO prices over the previous second.

Trade Through Results

Percent ISO Trade Throughs Full Sample by firm size Large Medium 2.7% 1.3% 1.7% 0.7% 2.2% 0.9% 1.7% Percent of NonISO Trade Throughs 0.9% Percent of Trade Throughs 1.3%

Small
by listing exchange NYSE NASDAQ

1.0%

0.5%

0.8%

1.8% 1.5%

1.2% 0.6%

1.4% 1.1%

Main Findings
Back and Baruch worked order equilibrium dominates market.
Average order size of ISO and non-ISO orders is 178.8 and 217.6 shares respectively. 89% of ISO orders and 86% of non-ISO orders are less than 500 shares. Distribution of ISO and non-ISO orders closely match.

Main Findings
ISO orders are dominated by informed traders.
ISO orders have higher effective spreads but lower realized spreads, relative to non-ISO orders. ISO orders have higher information share, relative to ISO volume, even with smaller trade size. ISO order use is increasing in market volatility.