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July 6, 2009

Flash Point

By Nina Mehta

Another significant issue raised by flash messages is the impact they could have on public limit orders. Ratterman points out that flash orders could affect the price-discovery process by curtailing the executions received by those establishing the NBBO. "A flash order takes advantage of the price-formation risk of someone at the NBBO without rewarding that person with an execution," he said.

Economist Harris agrees, but adds a caveat. "At present, executing at the NBBO is subject to the preferences of customers," he said. "It seems to be consistent with the present regulatory legal framework that traders on or off the exchange are allowed to match the NBBO on request. If you oppose this system, you're basically saying brokers or exchanges have a responsibility to satisfy clients of other exchanges, and regulators have never said that."

In his view, however, flash orders could affect the quality of the markets, if they come to represent enough liquidity. He describes flash orders as an example of exchanges competing for order flow at the expense of competition for the best price. "The implication is that traders would not post limit orders as aggressively as they otherwise would, and that would not be in the public interest," Harris said. "Theoretically, the bid-ask spread could widen." He added that the SEC "has been willing to protect traders offering liquidity at the NBBO only against trade-throughs in the name of protecting the order submitter [from executing at an inferior price]," but that the regulator may now have to think about the extent of the protection they are willing to offer those establishing the NBBO.

At the SIFMA conference, the SEC's Shillman said the Commission considers competition between limit orders critical to robust price discovery. If it appears that an increase in "dark volumes" is undermining that process, he said, the SEC might look at new ways to reward limit orders that establish the best price. One option he highlighted would be to give displayed limit orders at the NBBO protection against executions at the same price. That would require executions at the NBBO to first trade against the price-setting interest available in the displayed market.

Nasdaq's Hyndman doesn't think limit orders are likely to be affected by flash orders. "We don't think this market structure functionality is bad for limit orders," he said. "We don't know how it will play out, since it's a new innovation for exchanges, but we'll see what's changed after a couple months." He added that the SEC is likely to keep its eye on flash orders "in the same vein that they're keeping an eye on dark pool growth."