The Securities and Exchange Commission is worried about the impact of market centers’ “flash” order types on the price discovery process.
Speaking at an industry conference last week, David Shillman, an associate director in the SEC’s Division of Trading and Markets, said flash orders “could have benefits to order senders, but, on the other side, the party being harmed is the party with the displayed limit order at that price. That goes against broad Commission policy of encouraging and rewarding those who are willing to take the risk of displaying limit orders.”
The SEC official added that the agency is studying the issue of flash quotes as part of a broader reassessment of so-called “dark liquidity.” Shillman is the second SEC official to make public the agency’s concerns over trades done offboard in recent days.
As reported earlier by Traders Magazine, James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, and Shillman’s boss, told attendees at the Securities Industry and Financial Markets Association’s annual market structure conference the SEC was worried about order flow “diverted from the public markets” into dark pools. (Shillman spoke at the same conference.)
Flash orders first scan an exchange or an ECN for a fill and are then sent by the market center to a private network for a second chance at a fill. There they are “flashed” to the broker-dealer members of the network. If they are not filled in the private, or dark, network they are either cancelled or routed to another public marketplace.
The order types are currently offered by the Direct Edge ECN and the Chicago Board Options Exchange’s stock exchange unit. Nasdaq plans to debut two flash order types next month. BATS is said to be considering its own offering.
Direct Edge’s service, known as the Enhanced Liquidity Provider program, is the most successful. In April, the ECN matched 162 million shares per day through the three-year-old ELP program, according to the company.
Bill O’Brien, Direct Edge’s chief executive officer, maintains the integration of the public displayed market with hidden liquidity through the ELP program is a boon for the customer. Speaking at the SIFMA conference, he said it offers traders “lower transaction costs, increased fill rates, and a greater chance for price and size improvement.” Use of the flash order is optional at Direct Edge.
Critics of the order types voice various concerns. And like the SEC, they argue flash orders deprive limit-order traders on other exchanges of the chance to trade with the flashed orders. The orders slip into the dark, never to emerge again.
“The customer opting to route his order to the marketplace that offers this functionality does have a choice,” Joe Ratterman, CEO of BATS Exchange, told SIFMA attendees. “But the other customers who chose to display their orders on that market and other markets might be disadvantaged during the flash period. That is a big question.”
O’Brien argues that risk has always existed. Limit order traders have always had to stand by and watch trades done at their price either on other public markets or off-board, he said.
“If you feel somebody posting an order on one exchange is being disadvantaged…what you are really saying is that all liquidity should be forced onto exchanges. We should have an intermarket price-and-time priority rule. We really should have a CLOB.”
Shillman acknowledged that making a fair playing field for the two different traders was a balancing act, but indicated that it might be possible to formulate a rule that protected same-priced orders on different venues. “It doesn’t have to be a CLOB,” Shillman said, “there are other ways.”
The flash order type is legal under current SEC rules, but that could change, according to Shillman. SEC Rule 11Ac1-1, better known as the “quote rule” requires market centers to display quotes. But an exception is granted under the rule for those orders sent to a trading venue that are immediately executed or cancelled. The flash order type qualifies under that exception, Shillman explained.
“Now should it continue to be that way?” he asked. “It’s an open question as to whether the quote rule should be modified–whether it is really necessary to have that [exception] in the electronic world.”
