A Clear Market Fairness Issue Requires a Clear, Collective Response

For our modern marketplace to thrive, participants, operators, and regulators should meet standards of fairness and transparency to achieve trust. Trust is achieved when market participants have confidence that all available and relevant information about value is fairly reflected in the prices of financial instruments in a competitive marketplace.

The Chicago Mercantile Exchange (CME), unfortunately, is falling short of this standard by structurally allowing for the early dissemination of material trade data to a select group of customers before that same information is provided to the general public via market data feeds. This practice runs counter to the goal of a fair and efficient marketplace and CME leadership, along with regulators at the U.S. Commodity Futures Trading Association (CFTC) and Securities and Exchange Commission (SEC), should take steps to ensure the practice is discontinued.

Here's the problem: Currently, when a trade occurs on the CME, the passive counterparties near the top of the queue are informed of the trade's occurrence via a private fill report before the event is reported to the rest of the world via the public market data feed. This loophole not only provides a material advantage to a select group of firms, but it also incentivizes weird behavior that distorts the true supply and demand of the major financial products on the CME.

Because the largest CME private fill advantage is obtained by the orders nearest to the top of the queue, firms have an incentive to race to carefully position detector orders to capture the largest time advantage. Participants might line a price level with small, 1-lot, passive buy orders that they fully expect to take losses on so that even larger profits can be obtained by aggressively selling based on the early fill information gleaned – these detector orders are sometimes referred to as sacrificial "canary orders."

This information leakage, which happens on nearly every trade event, is significant to a special club of market participants yet detrimental to the overall market. First, it's significant because the early information is materially useful in trading profitably. Second, it's wrong because the information is made available to individual counterparties before the entire public marketplace. For example, large trade information gleaned from "canary orders" on the e-mini SP500 futures contract (ES) can be used to trade on various expiries of ES, other related futures instruments (NQ, EM, YM), and related equity instruments (SPY, QQQ, DIA), before the public market data event of that trade.

It's in the interest of the CME and regulators to break this asymmetry and restore the confidence of all market participants. Inaction would, unfortunately, normalize this unfair activity. Only participants embracing this questionable use of material, non-public, performance-enhancing information can remain competitive: once one firm begins to exploit access to early information, without a decisive response from regulators or exchange officials, other firms are driven to follow suit in order to remain competitive.

The main reason we believe regulators need to take action is that exchanges may be conflicted; it may difficult for market operators to unilaterally fix such data loopholes to be fair to all participants when their largest customers don't want this flow of beneficial information to cease. In fact, after a 2013 Wall Street Journal article initially exposed this practice, the CME went on public record extolling its commitment to public data transmission priority, only to once again quietly allow the unfair practice to be reintroduced.

The Solution:

Simply put, this practice can be regulated out of existence with a rule mandating the public dissemination of market data in all cases to precede private fill dissemination by a reliable amount. A measure of the median or average dissemination time separation is not enough – right now, in a highly queued book, CME queue leaders have a large time advantage while very late queue positions are reported later than the public feed. The whole point is that, independent of queue position, all private fills need to be reported explicitly later than the public feed. If one wants to know what is happening in the market, the single place to look for the earliest available information should only be the publicly available market data stream.

Regulators and market participants should have concerns about the quoting practices underlying the use of CME private fill information. It's clear a troubling grey area has emerged under current regulation. Rather than argue about the exact line constituting an abusive practice or what true intent is, the collective focus should be on the implementation of a smart, effective regulation ending this market distortion. The alternative, which is the current, asymmetric system exploited by a select few, seems unfair and not a practice we want occurring in our markets.