Ban on Flash Orders Is Considered by SEC

Schapiro Sees Inequity While Exchanges Wrestle for Market Share in High-Speed Trading
The Wall Street Journal
By SCOTT PATTERSON, KARA SCANNELL and GEOFFREY ROGOW
August 5, 2009
The Securities and Exchange Commission said it is considering a ban of "flash" orders, marking the firmest sign yet of the regulator's heightened scrutiny of cutting-edge electronic trading.
A flash order lets some traders have a sneak peek at market activity. SEC Chairman Mary Schapiro said she has asked the agency's staff to develop a proposal to "eliminate the inequity that results from flash orders." One person familiar with the matter said that means the SEC is studying a ban.
Meanwhile, Sen. Charles Schumer (D., N.Y.) last week wrote to the SEC demanding a ban on flash orders, which he said gave high-frequency traders an advantage over retail investors.
High-frequency trading, a lightning-fast, computer-based trading technique, now accounts for more than half of all stock trading in the U.S. Flash orders represent a much smaller part of the market, and are used by high-frequency and other traders.
Beyond the official scrutiny lies a tussle among exchanges for market share as high-speed trading becomes a central cog of the market. Exchanges are scrambling to cater to the high-frequency crowd, in part because the huge volumes they generate can make it easier for other traders on the exchange to execute orders.
NYSE Euronext, which operates the New York Stock Exchange, has been a vocal critic of flash orders, as several of its rivals have adopted some form of the trading method and have gained market share.
Wall Street players have lately expressed concern that too much regulation of high-speed trading could crimp markets. "Does this start a slippery slope?" said Raymond James analyst Patrick O'Shaughnessy, who covers brokerage firms and exchanges.
In a flash order, a firm wishing to buy or sell stock can elect to freeze the order on an exchange for as long as half a second. This move can have several effects, one of which concerns a system of rebates and fees on trading orders.
Typically on trades, exchanges pay rebates to traders who post shares to buy or sell and charge fees to traders who respond to those offers. This setup creates an incentive to earn rebates. A flash order puts a trader in the position of poster, rather than responder. The hope is that another trader who needs to buy or sell quickly steps in on the other side of the trade. This dynamic boosts the chance the flash-order trader will complete the trade on the exchange and get the rebate.
Critics say flash orders give a select group of high-speed traders a window into the direction of the market, giving them the ability to trade at lightning speeds ahead of less fleet-footed investors. Flash-order advocates say the orders help traders get better prices. They say a ban could cause trading volume to drop on the exchanges that permit flash as traders look for better execution in alternative, less-transparent venues.
Flash orders have been used for years but have become increasingly popular in recent months as more traders and exchanges adopted the approach. Still, they are a small fraction of overall trading, accounting for 2.4% of all U.S. stock trading in June, according to Rosenblatt Securities.
Meanwhile, in a sign of regulators' growing concern about evolving electronic trading, the SEC staff is also studying rules for so-called dark pools, private electronic-trading networks that match buyers and sellers anonymously. The pools have been gaining market share in recent years as more trading firms use them. Nasdaq OMX Group Inc. Chief Executive Bob Greifeld recently called for regulators to clamp down on dark pools.
The SEC staff is looking at requiring disclosure of post-trade information to show which dark-pool operator is executing which trades, according to people familiar with the matter. That would give investors a better idea of the liquidity and depth of a particular operator. The SEC is considering whether to have the information disclosed on a real-time basis or collected and disclosed in an aggregate form, these people said.
"The concern is if enough volume and order flow gets diverted into dark markets, at some point we would ask whether you would have reached a tipping point at which the public price discovery from displayed markets is being hurt," said Jamie Brigagliano, co-director of the SEC's trading and markets division. "It's not clear whether dark pools have reached that point yet. It's an issue we're thinking about," he added.
Another area under review is the "indications of interest," which are similar to flash orders. If an exchange can't execute an order, it will look at indications of interest from a number of dark pools. Rather than flash the order for a potential mate, the exchange can route it through the dark pools that expressed indications of interest. The SEC is considering whether these IOIs should be subject to order-handling rules and made part of the public centralized quotation system.
Ms. Schapiro said in a speech in June that she is concerned about transparency in dark pools, stating that "the lack of reliable information can prompt speculation and suspicion about the basis for market fluctuations."
A flash order proposal by the SEC would be subject to public comment and would require at least three of the five agency commissioners to approve it before it would become effective.
Flash orders were pioneered by the Chicago Board Options Exchange's stock exchange earlier this decade as that exchange looked for a way to improve execution speeds. Flash remained a niche part of the industry until around June 2006, when a small stock-trading platform, Direct Edge, owned by Knight Capital Group Inc., adopted the practice.
Direct Edge employees had seen flash used by traders at the CBOE, and used that model to unveil a version of flash that it called its Enhanced Liquidity Program, or ELP. Direct Edge's percent of matched market share of total stock trades shot up, to 12% today from less than 1%, according to Raymond James.
In 2007, Goldman Sachs Group Inc. and hedge fund Citadel Investment Group invested in Direct Edge.
Now, partly thanks to flash orders, Direct Edge is the third-largest stock trading platform by matched volume in the country, according to Raymond James. Its success has helped prompt competitors to adopt their own versions of flash.
William O'Brien, chief executive of Direct Edge, makes no apologies for the practice, saying flash has gotten investors better prices on larger orders roughly 10% to 15% of the time. Other times, he says, there isn't an impact on prices.
"Flash has shown price improvement and order-size improvement," said Mr. O'Brien, who joined the firm from the Nasdaq Stock Exchange in July 2007. "But it isn't front-running." He says even if flash orders are banned, his firm will do fine. Among other things, it has applied with the SEC for official exchange status, and there are other innovations under way, he says.