The Securities and Exchange Commission yesterday proposed to eliminate a loophole in a prominent industry rule that would, in effect, ban flash orders on equities and options exchanges. The unanimous vote by the five commissioners caps a summer-long fight in the media, among the public and on Capitol Hill about whether flash orders should be allowed in the securities markets.
However, the reasons that were detailed were straight market structure issues. They did not include broad concerns that retail investors were being taken advantage of through the use of flash orders.
Mary Schapiro, Chairman of the SEC, said yesterday in her opening remarks at one of the SEC’s regular open meetings that "flash orders have the potential to discourage publicly displayed trading interest and harm quote competition among markets." She also said the presence of flash orders could create "two-tiered markets" in which some market participants have access to information that is not available to the broader public market.
Schapiro and the other four commissioners rolled out a list of concerns about flash orders. Most notable, however, was the lack of discussion about the prospect that using flash orders potentially harms the execution quality of those firms employing that order type. This concern was raised, but, unlike the other concerns, got little airtime. One reason may have been the revelation that those using flash orders on Nasdaq and BATS Exchange were, by and large, not retail traders but high-frequency trading firms.
The main concerns highlighted were the potential impact flash orders could have on incentives to quote aggressively in the displayed market, and the prospect of two-tiered markets for information. Schapiro stressed the "unfairness" that results when firms that are not quoting the best price can nonetheless rely on information from publicly displayed quotes to execute against aggressively priced investor orders.
Flash orders are currently allowed under an exception to Rule 602, or the Quote Rule, in Regulation NMS. The Quote Rule requires market centers to publicly display their best prices. The exception offers an out for orders that are withdrawn and not executed immediately. The SEC’s proposed amendment to do away with flash orders by eliminating the exception will be open for comment for 60 days, once it appears in the Federal Register, before the SEC makes a final decision.
According to the SEC, the exception was adopted in 1978 when trading was done manually on floor-based exchanges. "In today’s highly automated trading environment, the exception for flash orders from quoting requirements is no longer necessary or appropriate," said James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, which proposed the amendment.
A flash order is a marketable order sent to a market center that is not quoting the industry’s best price or cannot fill that order in its entirety. The order is then flashed to recipients of the venue’s proprietary data feed to see if any of those firms wants to take the other side of the order. This practice enables the market center to keep the trade instead of routing the order to a rival market.
Direct Edge has offered flash orders for several years. In the first six months of this year, the ECN’s market share increased rapidly, to 11.9 percent from 6.9 percent at the end of 2008 (Direct Edge’s 2009 figures include volume from the ISE Stock Exchange, a subsidiary, although that volume accounts for less than half of 1 percentage point). Nasdaq OMX Group and BATS Exchange launched their versions of flash orders in June, but withdrew them in late summer in response to widespread outrage. NYSE Euronext, since May, has loudly criticized flash orders as a harmful market practice that disadvantages investors.
In a panel discussion on Wednesday afternoon sponsored by research firm Aite Group, William O’Brien, CEO of Direct Edge, said he believed flash orders had become a "politicized" issue. Elsewhere, he has argued that investors should be able to choose to use flash orders if they see benefits associated with the use of those order types. He has also argued that the "enhanced liquidity providers" that respond to flash orders on his market include dark pools, thereby democratizing access to those pools that investors might not otherwise reach.
Richard Gorelick, founder of RGM Advisors, an Austin, Texas-based proprietary trading firm that engages in high-frequency trading, said on a related panel that he agreed with O’Brien’s comment that flash orders had become politicized. "They may have been politicized to the point where the facts may not always matter," he said.
At the SEC meeting yesterday, the Commission’s Brigagliano laid out several reasons for nixing flash orders. He noted that flashing order information "could lead to a two-tiered market in which the public does not have fair access to information about the best available prices for a security that is available to some market participants." He also noted that flash orders give recipients of that information a "last-mover advantage" in deciding whether to trade at prices that are publicly displayed elsewhere.
Commissioner Elisse Walter acknowledged some of the reputed benefits of flash orders, such as lower transaction costs for their users, before arguing against them. "To the extent flash orders allow select market participants to execute orders at same price as the public quote without taking on the same risk of being publicly displayed, the use of flash orders could discourage the public display of trading interest and harm quote competition among markets," she said.
Two commissioners also noted that flash orders might be an issue that pits the interests of long-term investors against those of short-term investors. Chairman Schapiro and Commissioner Luis Aguilar suggested this.
Both noted that flash orders might detract from the fairness and transparency of the markets. Their comments floated the notion that flash orders might be a necessary sacrifice. "Flash orders appear to run a very real risk of aiding only short-term investors while interfering with the price competition that aids long-term investors," Aguilar said. He and Schapiro observed that the Commission must act in the interest of long-term investors.
SEC Commissioner Kathleen Casey said she supported the Division of Trading and Markets’ amendment if flashing orders disadvantages certain participants over others and discourages firms from publicly quoting their trading interest. She added, approvingly, that the amendment seemed "narrowly tailored," in her view.
Commissioner Troy Paredes raised the most issues with the proposed amendment and encouraged potential commenters to submit data about how flash orders affect market quality and displayed liquidity. "I support today’s proposal but am mindful that a ban is an unequivocal step," he said. He asked for comments about whether less-restrictive alternatives to a ban might be more appropriate.
Finally, Paredes offered a cautionary note on the SEC’s proceedings. "When the regulatory system erodes a market participant’s opportunity to profit from its legitimate competitive advantage, the incentive to innovate is dampened," he said. "Simply put, we need to guard against imposing regulatory constraints that unduly discourage innovation and competition."
Dan Gray, an executive in the Division of Trading and Markets, outlined yet another regulatory concern with flash orders. This concern gave explicit support to the notion that flash orders, despite media accounts, were not used primarily by retail brokers. Asked why flash orders, which had existed for several years, became more popular over the summer, he pointed out that a significant new "wrinkle" in the flash orders offered on Nasdaq and BATS altered the way flash orders were used and who used them.
The wrinkle, he said, was the decision of those two markets to pay rebates to firms flashing orders. On Direct Edge, in contrast, those flashing orders don’t get a rebate or any discount for making their orders flash-eligible. The result of this change, Gray suggested, was that flash orders were used by some firms to get around the prohibition on locking markets. A locked market occurs when the national best bid on one market is the same as the national best offer on another. (Flash orders got around the prohibition because they were not disseminated in the consolidated quote stream.)
Gray noted that offering rebates for flash orders "attracted the type of professional traders that are ultra-sensitive to rebates." Traders who would otherwise be paid a rebate to quote publicly could therefore use flash orders on Nasdaq and BATS, where they received a rebate if their orders were executed, to briefly lock the market and reap the benefit–and they could do so without showing their hand through a public quote. Gray added that "a fair part of the volume in those new markets came from that type of trader."
Gray’s statement about who was using these flash orders on exchanges undercuts the popular argument that flash orders were used mainly for retail investor flow. Instead, Gray’s comments made clear, orders flashed on Nasdaq and BATS were often used by high-frequency trading firms. Other industry sources suggest that the vast majority of executed flash orders on BATS and Nasdaq came from high-frequency trading firms.
