Last week, the US Securities and Exchange Commission (SEC) issued proposals to ban so-called flash order types on the basis that they benefit certain traders to the detriment of others. But market observers warn that further efforts to stamp out market inequalities could have unintended consequences.
“Hopefully the SEC proposal will only lead to some sort of ban or regulation on flash orders,” Larry Tabb, founder and CEO of research and consulting firm TABB Group, told theTRADEnews.com. “But if it goes much further than that, for example if we start getting into banning dark pools, sponsored access or co-location, then we are moving in a direction that will really harm the markets.”
Flash orders display details of unfilled, marketable orders on a trading venue either to a select group of the venue’s members or subscribers of its data feed for a brief period – typically 25 milliseconds – before the orders are routed elsewhere. Crucially, however, these flashes of information are not displayed on the US consolidated tape and so are not universally available. There are also concerns that traders with high-speed systems could use the information in the flashes to trade ahead of the original order.
Exchanges BATS and Nasdaq both voluntarily suspended their flash order types in August in the face of growing criticism of the practice. Equity trading platform Direct Edge continues to offer a flash function as part of its Enhanced Liquidity Provider programme, but is expected to support the SEC’s final decision on flash orders.
“Flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities,” said SEC chairman Mary Schapiro in a statement accompanying the ban proposal. “These flash orders provide a momentary head-start in the trading arena that can produce inequities in the markets and create disincentives to display quotes.”
Tabb contends that attempts to avoid inequality are “unrealistic” and would result in a market structure that caters to the lowest common denominator. “You then wind up with an antiquated marketplace that doesn’t benefit the majority of investors trading there,” he said. “Only a certain percentage of market participants are going to be able to take advantage of all the different opportunities. If we are saying that we need to build the markets for the lowest common denominator, we might as well go back to an open-air stall and start trading on the corner of Wall and Broad. That makes absolutely no sense.”
Sang Lee, managing partner of research and consulting firm Aite Group, thinks there is a “grey area” around whether combating two-tier markets is a valid reason to ban flash orders. He argues that regulators’ actions in the US equities market over the past 10 years have fostered competition. “So now we are beginning to think, ‘Maybe we have competition, but perhaps a select group of firms has an unfair advantage.’ What next?” he asks. “Are we going to try to restrict the way they compete and operate? That is a dangerous slope. If the market is going towards low-latency trading, why would we try to penalise the firms that have taken the lead in that regard?”
Regulators faced a similar dilemma when telephone traders complained of the apparently unfair advantages offered by electronic trading. “This is another inflection point around competition versus innovation,” says Lee. “And it is one of the major reasons why it is important that the SEC takes a step back and takes a broader view of the market structure.”
In her opening statement at an SEC open meeting last week, commissioner Elisse Walter said the proposal to ban flash orders would be a first step in a series of actions by the SEC as it examines market structure issues arising from recent developments in the equities and options markets. These include dark pools and indications of interest, Regulation ATS thresholds, sponsored access, high-frequency trading, and co-location. “The commission is looking closely at all of these matters to determine whether they raise policy concerns that are analogous to flash orders or otherwise may be detrimental to the fairness and efficiency of the national market system,” said Walter.
A potential next target for scrutiny could be direct market access (DMA). In her speech, Walter urged the SEC to investigate the “risks and concerns” arising from DMA in the near term.
Two weeks ago, the UK’s Financial Services Authority highlighted the risks of traders using brokers’ DMA services for ‘layering’ or ‘spoofing’ – submitting orders without the intention to trade in a bid to manipulate prices or create the impression of trading activity in a stock.
Concerns about dark pools are also not confined to the US. The World Federation of Exchanges has urged leaders of the G20 nations to focus on issues related dark pools at their summit in Pittsburg this week. And in a speech last week, Charlie McCreevy, European Commissioner for internal market and services, said that the European Commission’s MiFID review would address whether dark pools give an unfair advantage to their operators and whether their use undermines price discovery.
However, it may be tougher to clamp down on other activities than flash orders. Lee at Aite said flash orders were a particularly easy target for the SEC because of the public backlash against them and their relative insignificance. According to SEC figures, the proportion of equity flash orders that received an execution in July 2009 was 3.1% of the total trading volume.
“A flash order has questionable market transparency and questionable benefits to retail investors,” Lee added. “The problem is with dark pools is that they are not a homogeneous group, and have been with us since the beginning of trading.”
Any further changes, he argues, will need to be considered carefully as many of the areas the SEC is examining are inter-linked. “I don’t expect to see short-term, tactical decisions being made as all these issues are essentially tied together. I don’t think you could have one piece of regulation addressing dark pools or high-frequency trading without potential implications for all of the other areas.”