Most of you have probably heard some inflamed speeches deriding or supporting flash trading. The SEC has heard them, too.
On September 17, 2009, the Securities and Exchange Commission proposed to change Rule 602 of Regulation NMS in such a way that flash orders are no longer allowed. Now, the SEC solicits comments on the proposal. Along with other comments, the SEC "also seeks comment on whether the use of flash orders in the options markets should be evaluated differently than their use in equity markets."
Among comments already received were those from the International Association of Small Broker-Dealers and Advisers, supporting the change. This association refers to our modern system as a "horror movie" that harbors "over 50 dark pools [that] execute over 12 per cent of market trades" and internal trades at broker dealers, also outside public markets. The group warns that the public will lose confidence in the integrity of the markets if the system isn't changed. This group is more concerned with fairness to the long-term investor than liquidity.
However, in an earlier comment, Junius W. Peake, Monfort Distinguished Professor Emeritus of Finance, University of Northern Colorado, warns, "Approving the proposed rule about flash trading will once again increase the fragmentation of our market, a defect identified since 1975 (and even earlier) as one of the worst problems to be solved by the markets [sic] existing design."
So it is a good idea to ban flash trading or not? And what is flash trading anyway? The SEC describes a flash order as a temporary head start, using a stock purchase by a retail trader as an example. That retail trader places an order to buy at $10.00 a share, which happens to be the best-quoted price at that time. The retail trader's brokerage routes that order to a certain exchange, but none of that exchange's members have offered the stock at that price. The exchange can't execute the order at anything worse than the best quoted price. The exchange could then route the order to other exchanges. However, sometimes, it flashes the order to certain members rather than sending it to an away exchange. In a process that typically takes less than a second, the original exchange determines if it has a willing seller at the best quoted price before it sends the order to an away exchange.
The SEC's explanation points out that the flashed order isn't included in the consolidated quotation data stream. It's also not subjected to other rules such as locking or crossing orders. A locked market has been described as one in which an offer is quoted equal to the bid or the bid to the offer. A crossed market has been described as one in which the offer is lower than the quoted bid or the bid is higher than the quoted offer. The SEC notes that this Rule 602 exception allowing flashed orders was adopted in 1978, before the use of automated trading. It was intended to facilitate certain quotations of floor traders.
That exception is no longer needed, the SEC says, and gives an unfair advantage to certain exchange members, others say. The SEC worries that flash orders could lead to two-tiered system in which you and I, retail traders, don't always know what the true best available prices might be for a certain security. The SEC proposes eliminating that exception so that all marketable orders are displayed.
When Senator Charles Schumer (D., N.Y.) demanded that the SEC ban flash orders, he claimed that such orders give high-frequency traders who employed computer-based trading techniques an advantage over retail traders. An August 5 WSJ article points out that these high-frequency traders--or perhaps their computers--view orders just before retail traders do, also giving them an edge in guessing the direction of the market (Patterson, Scott and Scannell, Kate. "Ban on Flash Orders Is Considered by SEC"). Yet, some claim that the volume produced by the high-frequency traders provides liquidity to the markets, the same article notes. Orders execute more quickly, the theory goes. Spreads tighten. Courting these high-frequency traders actually benefits retail traders, these people believe. The WSJ article says that the CBOE pioneered flash orders, and it did so in an attempt to improve execution speeds, so the argument that it does so may bear weight.
But other consequences exist, consequences that benefit the exchanges themselves. Remember those exchange fees we see tacked on to our commissions when we buy or sell? When exchanges flash an order, they can and do freeze that order on the exchange to which it was first submitted, if only for that less-than-a-second period of time it takes to flash an order and determine if someone on the exchange is willing to take the other side or if it needs to be routed to an away market. Even if the time is less than a second, this whole process increases the chance that the first exchange can collected the fee for both sides of the trade.
When flash-trading expanded in the stock-trading arena, some stock-trading platforms were able to capitalize on the model to the benefit of investors with large orders, capturing trading volume by doing so. One executive was quoted as denying that the system could be described as front-running trades. It's dangerous to tinker with the system, some dissenters claim, and they worry about other regulation that might follow. The WSJ articles quotes a study by Rosenblatt Securities that says flash trades account for only 2.4 percent of all U.S. stock trading for June, so why all the worry?
Flash trading isn't the only occurrence that might be hampering the retail trader from clarity in price discovery. The formation of what's known as dark pools might also be a contributing factor. The WSJ article defines dark pools as "private electronic-trading networks that match buyers and sellers anonymously," and they've been growing in recent years. Some of these dark pools send out IOI's or indications of interest in trading at certain levels, and an exchange that receives such IOI's might be routing orders through the dark pools to see if they fill before sending them to away exchanges.
If you've got an opinion about flash trading, the SEC wants to hear from you, but your comments will be public and must be made within 60 days from the September 17 announcement. The link you'll need can be found here.