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December 14, 2009

2009 Review: The Past and Future of Flash Orders

Washington Strikes Back

By Nina Mehta

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A look at the national headlines that flash orders generated this past summer would have left any investor thinking these orders were ready to take over the trading world. However, that wasn't true, since the order type claimed just a shade over 3 percent of all equities volume. But that didn't stop some newspapers and even financial TV news network CNBC from "exposing" flash orders as a widespread and unsavory business practice undermining the integrity of the markets.

They weren't alone. Sen. Charles Schumer, D.-N.Y., skewered flash orders in July, threatening to introduce legislation that would ban them if the Securities and Exchange Commission didn't outlaw the orders. Sen. Ted Kaufman, D.-Del., took up the cudgel, charging that flash orders were a "telling example of rote piecemeal review by the SEC staff applying outdated floor-based precedents to electronic-age developments."

The SEC, whose staff had already identified regulatory concerns with flash orders, obliged the lawmakers. In September, the Commission issued a rule proposal banning these orders, which are sent to a select group of traders who get a peek at the order before it gets routed to other venues. But by then, Nasdaq OMX Group and BATS Exchange, the two market operators that had rolled out versions of flash orders in their markets over the summer, had "voluntarily" withdrawn those order types. Flash-order originators the CBOE Stock Exchange and Direct Edge still offer flash orders.

In Senate Banking Committee hearings on market structure in October, Frank Hathaway, chief economist at Nasdaq OMX, explained his firm's thinking. Nasdaq, he said, "had reservations about what [flash orders] would do to the market quality when we launched it, and when the SEC decided they would undertake rule-making in this area, we withdrew it." He said the flash order type was approved "perhaps without sufficient review when it first arose." He also said that the flash order "became something that was a missing part of our product suite," since rival markets had them.

Direct Edge, an electronic communications network in the process of becoming an exchange, gained the most benefit from flash orders. Direct Edge enabled participant firms with marketable orders that couldn't be matched on Direct Edge's books to interact with "enhanced liquidity providers," including brokers and dark pools, instead of having orders routing to away markets. A number of retail firms, in particular, chose to use flash orders.

Direct Edge's market share grew to 12.6 percent this past May, from 4.1 percent in May 2008, in part because of the popularity of innovations like flash orders and Direct Edge's pricing, which was aided by the bigger spreads it earned on flash orders. Flash orders represented 8.5 percent of the ECN's market share this past May.

NYSE Euronext and market maker GETCO were early vocal critics of flash orders. In May they argued that flash orders create a two-tiered market and an uneven playing field. But flash orders were also a big competitive issue between market centers, as Nasdaq attested.