This Thursday, the Securities and Exchange Commission is expected to reconsider whether market centers should be able to use flash orders. One possible outcome could be the end of flash orders on those markets that allow them.
The SEC has been under pressure for several months to reevaluate flash orders. However, these order types have staunch critics as well as supporters.
On Thursday, the five SEC commissioners will discuss a proposed amendment to the Quote Rule in Regulation NMS. The regulator, on its web site, said: "The Commission will consider a recommendation to propose an amendment to Rule 602 [the Quote Rule] of Regulation NMS under the Exchange Act that would eliminate an exception for the use of flash orders, as well as other related issues. If adopted, the proposals would prohibit the practice of displaying marketable flash orders."
Justin Schack, vice president for market structure analysis at institutional broker Rosenblatt Securities, said he did not know what the SEC might decide. "The SEC could ban them and say that no order types with any kind of flash-like functionality could exist, or it could do something around the margin, like require more disclosure or other tweaks that could allow flash orders to continue to exist with modifications."
Flash orders gained attention and notoriety this past summer when NYSE Euronext, market-maker GETCO and other firms criticized these order types. Flash orders, which enable participant firms on a particular market center to step up and match (or in some cases beat) the best price in another market, have been used by Direct Edge and CBOE Stock Exchange for several years. These order types offer a way for a trading venue to execute an order at the industry’s best price, even if they are not quoting at the best price, instead of routing the order to a rival.
However, flash orders were not considered controversial until Nasdaq OMX Group and BATS Exchange decided to roll out versions of these order types on July 1. Those order types were withdrawn by Sept. 1, in response to tremendous criticism.
Nasdaq and BATS launched their order types, in large part, to complete with Direct Edge, which gained 3.9 percentage points of market share in the first six months of this year. That boost did not come entirely from flash orders, but flash orders helped attract more volume. Another benefit Direct Edge has reaped from flash orders is a bigger pricing spread than the spread the ECN market earns on other orders, even though those firms using flash orders pay less to transact than they otherwise would on the ECN. This richer pricing spread has enabled Direct Edge to pay more, in general, to the highest-volume liquidity providers on its market than its main rivals pay on their exchanges.
The objections to flash orders commenced in May and reached a fever pitch in late July. Senator Charles Schumer, D-N.Y., and Sen. Ted Kaufman, D-Del., have both publicly criticized the use of flash orders, charging that these order types are unfair and hurt ordinary investors.
SEC Chairman Mary Schapiro responded to the criticism. In early August, Schapiro said she had asked her staff to develop a proposal to "eliminate the inequity that results from flash orders."
The SEC will now consider a proposed amendment to the Quote Rule. David Shillman, an associate director at the Commission’s Division of Trading and Markets, said at a Securities Industry and Financial Markets Association conference on market structure in May that flash orders lasting less than 500 milliseconds fall within an exception to the Quote Rule, or Rule 602, in Regulation NMS. The Quote Rule requires all market centers to publicly disseminate their best bids and offers through the securities information processors. The exception Shillman referenced is for orders that are immediately executed or canceled.
However, Shillman said at the May conference, the SEC’s thinking on this issue wasn’t settled and might be re-examined. "It’s an open question as to whether the Quote Rule should be modified, whether it is really necessary to have that [exception] in the electronic world," he told the SIFMA crowd. If the exception now disappears, as the SEC noted, the "practice of displaying marketable flash orders" would end.
William O’Brien, CEO of Direct Edge, has argued that flash orders can benefit retail and institutional firms, and has said that investors should be able to use these orders if they wish. "We agree with the measured, holistic approach the SEC has indicated it will take in an effort to better and more effectively understand market structure and how the markets have evolved over the past several years," he said. "We trust the [SEC] will not rush to judgment, will garner as much data as possible and seek constructive input from the industry and investors."
Randy Williams, a spokesman for BATS Exchange, said his company is also taking a wait-and-see approach. He said: "As we’ve said in newsletters and on panels over the past several months, it’s important that the industry closely examine this functionality and the serious issues it raises. We look forward to participating in the process." Joe Ratterman, CEO of BATS, said several times over the summer that BATS decided to offer flash orders to avoid giving Nasdaq an edge once Nasdaq decided to roll out flash order types.
