THE BLOTTER | 29 October 2013 | Volume 4 | Issue 11
The Blotter presents ITG’s insights
on complex global market
structure, technology, and policy
issues.
The Cost of the D-Quote
Introduction
Contributors
Jeff Bacidore
Managing Director
Ben Polidore
Managing Director
Wenjie Xu
Assistant Vice President
contact
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[email protected]
www.itg.com
Traders commonly use market-on-close (MOC) or limit-on-close (LOC) orders to
participate in the NYSE closing auction. An alternative mechanism is the D-Quote.
Unlike MOC/LOC orders, which must be submitted prior to 3:45 unless offsetting a
Regulatory Imbalance1, D-Quotes can be submitted or modified until 3:59:50,
regardless of the current imbalance. Given the greater flexibility of D-Quotes, why
don’t traders always use D-Quotes when participating in the close?
In this note, we discuss the cost and benefits of D-Quotes. Specifically, the main
benefit of D-Quotes is flexibility: D-Quotes can be submitted later than MOC/LOC
orders, have no imbalance-related restrictions, and can be canceled until 3:59:50.
The downside of D-Quotes is their tendency to be more impactful than similarlysided MOC orders, which we document empirically. Also, D-quotes involve additional
operational risk due to their manual nature. Therefore, while D-Quotes may be useful
in certain circumstances, their incremental flexibility comes at the cost of greater
price impact and additional operational risk.
Overview of D-Quotes
D-Quotes can be used by floor traders throughout the trading day, including the
opening and closing auctions, and allow floor traders to represent orders
electronically but with “discretion” (the “d” in D-Quote).2 D-Quotes can be entered
manually by the floor trader or can be received electronically, though orders
submitted electronically must still be manually accepted.3 D-Quotes can participate
exclusively in the closing auction, regardless of the existing imbalance – opposite or
same side. D-Quotes can be submitted, modified or canceled at any time until
3:59:50 PM, which is nearly 15 minutes later than the cutoff for MOC/LOC orders at
3:45 PM. In addition, D-Quotes submitted to the closing auction are hidden from the
public until 3:55 PM, at which time they are included in the NYSE closing imbalance
message.
The benefits of D-Quotes are that they are more flexible than MOC/LOC orders. This
flexibility can be useful to traders who miss the 3:45 PM MOC cutoff, as well as for
traders who aren’t committed to trading in the closing auction and may want to
Regulatory Imbalances are generally larger than 50,000 shares. Traders may send offsetting MOC/LOC orders in
response to Regulatory Imbalances. Otherwise, all MOC/LOC orders must be submitted prior to the 3:45 PM cutoff. See
Bacidore, Polidore, Xu, and Yang (2013) for more details.
2
For more detail on D-Quotes, see NYSE Rule 70.25.
3
Floor brokers can accept multiple orders at a time.
1
29 October 2013 | Volume 4 | Issue 11
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cancel later. Also, a trader working a large order may use a D-Quote simply to delay
when their trading interest is included in the imbalance feed.
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The downside of the D-Quote is that the market has only 5 minutes to offset any
significant imbalance revealed in the imbalance feed at 3:55 PM. And unless an
opposite-sided Regulatory Imbalance already exists, traders can only offset this
imbalance using D-Quotes. The short time frame coupled with relatively limited
means of offsetting any imbalances can make large D-Quotes more impactful than
similarly sized MOC orders, which we investigate empirically in the next sections. The
other potential downside is the manual nature of D-Quotes, which can lead to
increased operational risk (e.g., a floor trader does not acknowledge the order in a
timely manner and misses the close).
Price Impact of D-Quotes
To better understand how prices respond to closing auction imbalances, we analyze
how the market responds to imbalance information released at 3:45 PM, which
contains only MOC/LOC imbalances, and to imbalance changes occurring when
D-quotes are included at 3:55 PM. Since stocks with Regulatory Imbalances can be
offset via MOC/LOC after 3:45 PM, we exclude Regulatory Imbalances from our
sample to avoid mistakenly attributing imbalance changes around 3:55 PM to
D-quotes when they were in fact due to MOC/LOC orders.4
Using imbalance feed data on all NYSE stocks for Q2 2013 (excluding Russell
rebalance and triple witching days), we measure the price dislocation between 3:45
PM and the closing print.5 These dislocations depend critically on how D-Quotes
affect the imbalance when they are included in the imbalance feed starting at 3:55
PM. Note that there are 5 different scenarios that could occur when D-Quote
imbalances are included. D-Quotes can either:
¬¬ Increase an existing MOC/LOC imbalance;
¬¬ Have no impact on the imbalance at all (i.e., the change in imbalance is exactly
zero);
¬¬ Decrease an existing MOC/LOC imbalance, but only partially;
¬¬ Decrease an existing MOC/LOC imbalance exactly to zero; or,
¬¬ Flip the direction of the MOC/LOC imbalance from sell to buy, or buy to sell.
In Exhibit 1, we show the empirically estimated price paths for the 5 different
scenarios. When D-Quotes are included in the imbalance at 3:55 PM, prices move
further in the direction of the imbalance if they add to an existing imbalance, but
revert if D-Quotes reduce imbalances. And when D-Quotes have no impact on the
imbalances, there is no significant price impact at 3:55 PM.
Regulatory imbalances occur in about 8.7% of cases in Q2 2013.
Stock price dislocation refers to the price difference between the closing print and the market price at 3:45 PM. They are
adjusted for market movement and standardized by the spread.
4
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EXHIBIT 1:
Potential close price dislocation paths for closing auction order placement before 3:45 PM via D-Quote
15.00
10.00
5.00
0.00
Increase imbalance
Decrease imbalance to 0
Do not change imbalance
Close
4:00
3:59
3:58
3:57
3:56
3:55
3:54
3:53
3:52
3:51
3:50
3:49
3:48
3:47
3:46
-5.00
3:45
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Mean price dislocation (bps)
20.00
Decrease imbalance but not flip imbalance side
Decrease imbalance and flip imbalance side
Overall
Source: ITG
Exhibit 1. Difference in mean price dislocation for closing auction orders placed via
D-Quote vs. traditional MOC/LOC placement before the 3:45 PM cutoff. Closing
auction orders may increase, decrease, or not change the imbalance; if they decrease
the imbalance, they may decrease it, decrease it completely, or decrease it by so
much that the imbalance side reverses.
Price Dislocation of D-quotes vs. MOC orders
We next run simulations to determine whether a given order would have more impact
if sent as a D-Quote instead of an MOC order. The details of the simulations are
contained in the Appendix. Intuitively, we model how prices respond to imbalances
created at 3:45 PM and to those created at 3:55 PM using actual NYSE imbalance
data. This allows us to determine not only the immediate price impact at the time of
the imbalance, but also how the market responds to the imbalances over time (e.g.,
due to the arrival of offsetting orders). It is important to note that while our results
are “simulated” in the sense that they are hypothetical, our “what ifs” are based on
what actually happened in response to real imbalances created in the market in Q2
2013, so are not purely theoretical. Rather, we rely on simulations simply to help us
characterize the relationship between imbalances and price dislocation in a more
intuitive, apples-to-apples manner.
Exhibit 2 shows how the cost of MOC/LOC orders compare to similarly sized
D-quotes. This chart shows that D-Quotes are generally more impactful than MOC/
LOC orders, with the possible exception of the smallest order sizes when no
significant difference exists. And as order sizes increase, D-quotes generally become
even more impactful than MOC/LOC orders. This may not be too surprising given that
the market only has 5 minutes to absorb any imbalance and can typically only do so
by using D-Quotes.
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4.00
Using D-Quote - Using MOC/LOC
3.50
3.00
2.50
2.00
1.50
1.00
0.50
90
80
70
60
50
40
30
20
10
0.00
0
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Difference in mean close price dislocation (bps)
EXHIBIT 2:
Difference in mean close price dislocation of using D-Quote and using MOC/LOC
Order size (20-quantiles of typical imbalance volume)
Source: ITG
Exhibit 2. Difference in mean price dislocation for closing auction orders placed via
D-Quote vs. traditional MOC/LOC placement before the 3:45 PM cutoff. For example,
if we place an order for the closing auction via the D-Quote where the size is in the
50th percentile of imbalance volumes, D-quotes will be about 3 bps more expensive
than an identical MOC order.
Conclusion
D-Quotes offer traders greater flexibility than MOC/LOC orders. Traders can submit
and cancel D-Quotes up to 10 seconds before the close, regardless of the size or
direction of any existing MOC/LOC imbalance. This is particularly useful for traders
who are not committed to trading in the close as well as those that simply missed
the MOC/LOC cutoff. But such participation comes with potential costs. D-Quotes
are generally a more costly way to participate in the closing auction since they create
greater price dislocation than similarly-sized MOC orders on average. D-Quotes also
have increased risk due to the manual nature of D-Quotes. This risk is especially
pronounced when markets are under stress or near the D-Quote cutoff time.
Therefore, D-Quotes are not a good substitute for MOC orders. Rather, they simply
provide greater flexibility, at the expense of greater price impact and potentially
greater risk.
29 October 2013 | Volume 4 | Issue 11
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References
Bacidore, J., B. Polidore, W. Xu, and Y. Yang, “Trading Around the Close”, Journal of
Trading, Vol. 8, No. 1 (Winter 2013), pp. 48-57.
APPENDIX: METHODOLOGY
THE BLOTTER
We run simulations to determine how much price dislocation a given order would
cause if submitted as an MOC order or as a D-quote. To do this, we use actual
imbalance information data to characterize how markets react to imbalances created
by imbalances due to MOC/LOC orders (at 3:45 PM) and those created by D-quotes
(at 3:55PM).
As noted above, there are 5 different price paths that a given order could have
followed had it been sent as an MOC/LOC and included at the imbalance as of 3:45
PM. For each path and time period, we build a model to estimate the price
dislocation using predictors such as the corresponding MOC/LOC imbalance and/or
D-Quote size. We also build a model estimating the D-Quotes size using the initial
MOC/LOC imbalance. Thus, given an initial order size, we can use these models to
simulate the price path when our order is added to the initial MOC/LOC imbalance or
to the D-Quote.
With these models in hand, we run our simulations as follows. We first fix the
hypothetical order size. We then create a simulated trade by first assuming that this
order was sent as an MOC order. For this particular “draw”, we first randomly
determine the initial MOC/LOC imbalance as of 3:45 PM . We then randomly pick one
of the five potential price paths for this draw, with the probability of any path being
chosen being determined by how frequently each path occurs in the historical data.
For example, if the probability of an imbalance being reduced after 3:45 PM were
40%, then we would draw that path with probability 0.4 (i.e., 40% of the time). We
then compute the expected price dislocation for this draw and store it. We repeat
this process over a large number of draws to get a sample of possible price
dislocations that this order could generate.
To compute the average dislocation for an MOC order of this size, we simply average
the price dislocation across all draws. We then repeat this process but assume that
the order was submitted not as an MOC, but as a D-Quote. We can then compare the
average price dislocation of the MOC order to the average simulated price dislocation
of the identical D-quote, and plot this point in Exhibit 2. We then repeat this process
until we have the 10 data points in Exhibit 2, one for each hypothetical order size.
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