Buy-side warned on ‘flash’ order types

Order types that briefly display unfilled marketable orders to a trading venue’s members before routing them elsewhere can benefit the buy-side, but there are also potential dangers inherent in their use, industry experts suggest.
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Order types that briefly display unfilled marketable orders to a trading venue’s members before routing them elsewhere can benefit the buy-side, but there are also potential dangers inherent in their use, industry experts suggest.

The practice of using so-called flash order types first came to prominence in early 2006 when US equities trading platform Direct Edge launched its Enhanced Liquidity Provider (ELP) programme. Under the scheme, if an order cannot be matched on Direct Edge, an indication of interest (IOI) is sent to the participating liquidity providers, typically brokers and high-frequency proprietary traders. If there is still no match, the order is routed on or cancelled according to the user’s instructions.

In the past month, other US venues have introduced their own versions of the scheme, ostensibly because of Direct Edge’s recent success in grabbing market share. BATS Exchange introduced BATS Optional Liquidity Technology (BOLT) service on 4 June. Exchange group Nasdaq OMX introduced Nasdaq-only Flash orders on 5 June this year and added Flash-enhanced routable orders on 8 June.

In May, Direct Edge’s matched market share of US equities was 12.55%, up from 7.90% in January and 4.05% in May 2008. The platform has now overtaken BATS to become the third-largest equities trading venue in the US by matched market share.

Flash order types differ from venue to venue. On BATS, for example, marketable BATS-only BOLT orders are displayed to market participants for up to 500 milliseconds before being cancelled, while routable BOLT orders are exposed to participants for up to 25 milliseconds before they are cancelled or routed to other market centres.

The order types have the potential to boost venues’ liquidity and market share but there are also benefits to

members and their buy-side clients. Firstly, flash orders offer the possibility of executing more size before orders are displayed in the public markets. “For the buy-side, these order types are mainly intended to access liquidity while minimising visibility of their orders in the market,” Michel Debiche, president and CEO of quantitative investment advisory firm Quantia Capital Management, told

The order types can also generate rebates. For example, BATS’ routable BOLT orders pay users a rebate if the order is filled within the 25-millisecond exposure period. If the order were filled within BATS, users would also avoid the routing charge that would apply if it had been sent to another market. BATS-only BOLT orders are paid a full liquidity rebate if filled in the exposure period. Such rebates are often passed on by brokers to buy-side quantitative trading houses.

However, the process of displaying the orders to participants and liquidity providers could result in information leakage. “One problem is that the ‘darkness’ of this type of order may be illusory or worse, as the consumers of these short-duration, flashed quotes are, not surprisingly, often high-frequency shops, who can interpret them as imminent demand across the current spread and try to trade ahead,” said Debiche.

“There are questions about the potential for gaming with these order types,” agrees Miranda Mizen, principal at research and advisory firm TABB Group. “Because markets now deal in microseconds, a lot can happen in 25 milliseconds. There needs to be some assurance that nothing bad will happen on the back of someone seeing the orders.”

Furthermore, argues Mizen, the practice of keeping orders back could cause users to miss better prices on other venues. “You need to weigh the potential for price improvement and speed against the possibility of missing the market,” she said.

The order types have attracted a lot of controversy in recent weeks. Exchange group NYSE Euronext, owner of the New York Stock Exchange, has been their most vocal opponent. On May 28, before Nasdaq and BATS received approval for their new order types, the exchange wrote to Elizabeth Murphy, secretary of US regulator the Securities and Exchange Commission, arguing that the two exchanges’ proposed order types “would impede a free and open market and a national market system” and that the pre-routing display functionality in particular “circumvents the original purpose of Regulation NMS”.

Despite approving BATS’ and Nasdaq’s new order types, the SEC is clearly keeping a watchful eye on developments in dark pool trading. In an 18 June speech, the Commission’s chairman, Mary Schapiro, voiced concerns about non-displayed venues’ use of IOIs – in particular their dissemination to select clients and the resulting creation of “private markets”.

However, others downplay the concerns about the new order types. “There is always for a risk of gaming in an electronic trading environment,” argued Sang Lee, managing partner at research and consulting firm Aite Group. “Traders would probably prefer to execute quickly and discreetly than capture a penny price improvement.”

However, although the SEC has approved the order types, the regulator is likely to keep a close eye on them.

“If the venues that use these programmes continue to gain traction, I believe the SEC will revisit them,” said Lee.