The Cost Of The D Quote

Jeff Bacidore
Managing Director, Head of ITG Algorithms Ben Polidore
Managing Director, ITG Algorithms Wenjie XU
Assistant Vice President, ITG Algorithms

10/28/2013

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 similarly sided 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 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.

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 off setting 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.