SEC review sparks war of words on flash orders

Market participants are fiercely divided on whether the US Securities and Exchange Commission (SEC) should follow through on its proposal to ban ‘flash’ orders in the US equities and options markets, according to responses submitted during the comment period, which closed on Monday.
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Market participants are fiercely divided on whether the US Securities and Exchange Commission (SEC) should follow through on its proposal to ban ‘flash’ orders in the US equities and options markets, according to responses submitted during the comment period, which closed on Monday.

Some respondents, including exchanges, mounted a robust defence of the controversial order types, which briefly display unmatched, marketable orders to either select participants or subscribers of proprietary market data feeds before routing them elsewhere. Others have supported the SEC’s proposed ban with equal vehemence.

On September 16, the SEC proposed eliminating the exception in Rule 602 of Regulation NMS that allows flash orders, and gave the market 60 days to respond.

The exception originated from the time allowed to floor traders to apply to quotes considered ‘ephemeral’ – so fleeting that it would be impractical to include them in consolidated quotation data.

Prominent supporters of flash trading in the US equity market include ECN Direct Edge, which has been using flash order functionality in its Enhanced Liquidity Provider Programme since early 2006 to display unfilled orders to a select group of market makers before onward routing, thereby enhancing the chances of a fill on its platform.

In Direct Edge’s submission, Eric Hess, the firm’s general counsel, argues that simultaneously displaying interest to multiple parties during the execution process is beneficial to both long- and short-term investors, and uses proprietary trading data to demonstrate that price improvement is higher, price slippage is lower and that limit orders displayed on other markets are not materially impacted as a result of using flash orders.

“Simply put, the prohibition of this technology will not promote efficient execution of investor transactions, and thus investor confidence, over the long term,” Hess asserted. According to Direct Edge, price improvement on flash-eligible orders on the ECN’s book was 7.82% in June and 8.84% in July, compared with 2.62% and 2.67% respectively for non-flash-eligible orders.

Direct Edge was the only one of its equity-trading peers not to voluntarily ban its flash functionality in August this year. Both Nasdaq and BATS dropped their equivalent order types when it became apparent that the SEC was likely to take action.

Strong support for flash functionality also came from traditional ‘classic fee’ options exchanges (those which eschew maker-taker pricing) with the Chicago Board Options Exchange (CBOE) arguing that it allows exchanges to ‘step up’, i.e. match or improve on, the national best bid and offer (NBBO) when it does not currently reside with them.

“The proposed ban would inflate costs for those the ban seeks to protect – retail investors,” said William Brodsky, chairman and CEO of CBOE, in his firm’s submission. “The ability to match is particularly attractive to retail brokerage firms because it allows them to get NBBO executions on CBOE without incurring significant execution fees imposed by maker-taker exchanges.”

Both the International Securities Exchange and proprietary trading firm Citadel also submitted defences of flash orders in the US options markets.

Retail market players appeared to agree with the options exchanges. Christopher Nagy, managing director, order strategy, at retail broker TD Ameritrade warned that implementing the proposal as is would “inflict higher costs, less liquidity and unintended and unforeseen consequences to the individual investor particularly to the listed options markets.”

However exchange operator BATS Global Markets, which until August offered a flash variant, BOLT, on its primary US platform, BATS Exchange, hit back at options exchanges’ claims about the benefit of flash orders in an apparent swipe at its future rivals’ business models. BATS plans to launch a US options exchange in early 2010.

“BATS wholeheartedly disagrees with the conclusion that banning step-up auctions would negatively affect retail customers,” said BATS’ senior vice president and general counsel Eric Swanson in his company’s submission. “Rather, BATS believes that banning flash in the options markets would reward markets that are transparent about their fees, as well as reward market participants who contribute to price discovery. As a result, retail investors would be rewarded with better execution prices and overall lower cost.”

BATS supports banning flash orders in both the options and equity markets, arguing that the negatives outweigh any benefits. The exchange contends that flash orders, among other things, allow price-forming resting orders at other venues to be traded around, and lead to a disconnected consolidated quote stream that does not reflect the market’s best prices.

The New York Stock Exchange, a vocal opponent of flash orders, also supported a ban, but urged the SEC to give its proposal a sharper focus, as it fears simply striking out the offending section of Rule 602 could impede other practices which it deems non-harmful.

“Eliminating Rule 602(a)(i)(A) would have a negative outcome for our national market system by eliminating longstanding and appropriate trading practices, such as floor broker price discovery on both equities and options trading floors and the use of IOCs [immediate or cancel orders],” said Janet M. Kissane, senior vice president and legal and corporate secretary at NYSE Euronext.

Other respondees warned of the potential consequences of regulating select market practices without considering the effect on the wider market and collecting the necessary data to prove they are harmful to investors.

“Just as a botanist would not discuss the leaf of a tree without first discussing the tree itself, Knight believes it is premature to discuss specific order types when the overall market structure must be explored first,” argued Leonard Amoruso, general counsel at broker Knight Capital Group. “Let data analysis drive the discussion of the merits of flash trading. Knight understands both sides of the debate. Whether this order type, which impacts a small fraction of all orders, is found to be operating to the detriment or benefit of investors should be part of the overall market structure debate.”