July 27 (Bloomberg) -- High-speed trading in the U.S. stock market may face its biggest threat after Senator Charles Schumer proposed prohibiting so-called flash orders.

Schumer, the third-ranking Senate Democrat, urged the Securities and Exchange Commission to ban the practice in which some equity exchanges hold orders to buy and sell shares for a split second before publishing them on competing platforms. Nasdaq OMX Group Inc., Bats Global Markets and Direct Edge Holdings LLC, which handle more than two-thirds of the shares traded in the U.S., offer flash orders to their customers.

Schumer’s July 24 letter raises the stakes in a debate over whether computer-driven trading by hedge funds and Wall Street firms gives them an unfair advantage over other investors. While flash trades make up less than 4 percent of U.S. stock volume, they’ve drawn criticism from the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group, and New York-based NYSE Euronext.

“It’s an arms race driven by technology,” said Sang Lee, managing partner at financial-services consultant Aite Group LLC in Boston. “Someone like Chuck Schumer getting involved in the process will create a deeper conversation about where the whole market is headed.”

NYSE Euronext, owner of New York Stock Exchange, told the SEC in May that flash trading results in investors getting worse prices. Holding orders may give certain customers the opportunity to gauge supply and demand before they take action with computer systems that execute orders in milliseconds.

Legislation Threat

Erik Hotmire, an SEC spokesman, declined to comment. Ray Pellechia of NYSE Euronext and Randy Williams of Bats also didn’t respond to requests for comment. NYSE are based in New York. Bats has its headquarters in Kansas City, Missouri.

Schumer, a member of the Senate Banking Committee, said in a letter to SEC Chairman Mary Schapiro that he will introduce legislation to ban flash orders if the regulator doesn’t act on his request. He said the practice lets brokerages using rapid- trading programs “profit from advanced knowledge of buying and selling activity.”

“This kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system, where a privileged group of insiders receives preferential treatment,” Schumer wrote. “If allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets.”

Fastest Growing

Robert Greifeld, the chief executive officer of Nasdaq OMX, encouraged the SEC to “address all types of developments in the area of increasing public visibility of securities orders,” according to a letter to Schapiro released by the company today.

“Flash orders are but one symptom of the current evolving market structure,” Greifeld wrote. “Nasdaq OMX is concerned that the securities industry appears willing to accept more and more ‘darkness’ and limits on the availability of order information.”

Direct Edge is the fastest-growing equity market in the U.S., helped by its three-year-old Enhanced Liquidity Provider program, which handles more flash trades than any other exchange. Chief Executive Officer William O’Brien said in a July 24 interview that the program is available to any brokerage. Investors choose to have their orders held to raise the odds trades will be executed and gain access to platforms that otherwise restrict access, such as New York-based Liquidnet Inc.

‘Warrants Debate’

“Anybody can be part of it,” said O’Brien, who is based in Jersey City, New Jersey. “This is something that warrants a debate, and when you have so many competing interests, we think the SEC is in a better position to fulfill that.”

Some investors say computer-driven strategies executing hundreds of trades a minute make stock prices more volatile and boost costs. NYSE Euronext estimates that about 46 percent of daily volume is executed through high-frequency strategies.

Getco LLC, one of the biggest firms using high-frequency trading to make markets in stocks and options, told the SEC that brokers may grow reluctant to post publicly accessible quotes, opting instead to wait for flashed orders. That will lead to worse prices for investors, the Chicago-based firm said in a letter to the SEC last month.

U.S. equity markets have catered to high-frequency traders for the past decade by offering rebates on transaction fees. Exchanges also rent space in their data centers so brokerages can cut the distance information must travel and reduce transaction times, potentially getting an edge over competitors.

New Laws

“You have all this activity going on that in one way or another is preferencing one part of the investing group over another,” said Michael Panzner, author of “The New Laws of the Stock Market Jungle” and a Wall Street trader for a quarter century. “That’s not good.”

More than 75 percent of hedge funds, pensions and mutual- fund companies use computer-driven strategies because they reduce costs, according to a survey this month conducted by Greenwich Associates, a consulting firm in Stamford, Connecticut. Their trades are placed through Wall Street’s largest brokerages, which account for two-fifths of high- frequency trading, NYSE estimates.

Goldman Sachs Group Inc., the second-largest market maker pairing off buyers and sellers at the NYSE, doesn’t use flash- order systems, spokesman Ed Canaday said in an e-mail.

“Goldman Sachs believes high-frequency trading should have an accompanying obligation to provide liquidity, and be subject to appropriate regulatory oversight,” Canaday said.

Traders including David Lutz say automated brokerages boost liquidity, increasing the likelihood that buyers and sellers will agree on a price. Competition has driven bids and offers for some of the most widely held stocks, including Microsoft Corp., Citigroup Inc. and General Electric Co., to 1 cent in the U.S., according to data compiled by Bloomberg.

“When high-frequency traders are in the stocks I’m trying to execute, it helps me find the best execution,” said Lutz, a managing director of equity trading at Stifel Nicolaus & Co. in Baltimore. “It’s completely benign to me.”

To contact the reporters on this story: Edgar Ortega in New York at ebarrales@bloomberg.net; Eric Martin in New York at emartin21@bloomberg.net.

Last Updated: July 27, 2009 18:22 EDT