Direct Edge Holdings LLC, the fourth-largest U.S. equity exchange, is changing the way it handles flash orders, the split-second requests to buy or sell stock that regulators proposed banning last year.
Flash trades drew scrutiny from the Securities and Exchange Commission because they allow participants on a trading venue to see equity orders before they’re sent to rival markets. Under Direct Edge’s plan, buy and sell requests that were previously flashed would be held for a fortieth of a second while an auction is held to fill them.
Calls in Congress 16 months ago to ban the practice showed growing public concern over U.S. exchange structure following a decade of legislation that reduced the role of humans in making markets. Direct Edge, which has resisted calls to outlaw flash orders, outlined its plan in a government filing published on Nov. 18 as a way to improve pricing for investors.
“It’s a product customers have wanted us to pursue and choose to use every day,” said William O’Brien, chief executive officer of Jersey City, New Jersey-based Direct Edge. “Now it’s a micro auction. We’ve always prided ourselves for being innovative. It has been enhanced and reborn.”
The SEC proposed prohibiting the orders in securities markets in September 2009 after NYSE Euronext, automated-trading firm Getco LLC and Senators Charles Schumer and Ted Kaufman said they disadvantaged some investors. The debate followed the adoption of flash trades by Nasdaq Stock Market and BZX Exchange to compete with Direct Edge in June 2009. Both stopped permitting them within three months.
While the SEC hasn’t yet issued a ruling, the controversy accelerated a broader review of trading, including the growing importance of speed in markets and increasing competition among exchanges. The May 6 plunge, which briefly erased $862 billion in equity value, fueled the debate.
More than 50 platforms compete for orders in the American equities market. All are governed by SEC rules that prevent venues from trading investors’ shares at levels inferior to the so-called national best bid or offer available to the public. The flash debate concerns the way market centers competing with one another handle a segment of the hundreds of thousands of orders submitted daily by brokers to automated exchanges.
Under the standard, a trading platform may hold an order for less than half a second before sending it to a competitor quoting a better price. For someone to execute against it, he must match or improve the price prevailing in the national marketplace at that time.
CBOE Stock Exchange, the market that devised the idea of flash orders for stocks, uses them to allow investors in Chicago to get quicker executions than waiting for a response from companies whose computers are based in New York or New Jersey. CBSX is operated by CBOE Holdings Inc.
While orders about to be sent to other markets are still shown to select customers under Direct Edge’s plan, they’re no longer filled on a first-come, first-served basis. Since July, when Direct Edge’s two venues became exchanges, the best-priced order at the end of the auction trades against the request if it can match or exceed the national price.
“In the 25-millisecond period all responses are collected, and the execution is done on the basis of who provides the best price,” O’Brien said. The auctions will allow retail brokerages, trading firms and others to seek better prices on Direct Edge, he said. “It de-emphasizes speed and re-emphasizes price and opens the field to a broader array of potential competition,” he said.
The auctions don’t guarantee executions at Direct Edge. Orders are routed elsewhere if they can’t be traded at the best price in the market, O’Brien said.
Supporting a Ban
Nasdaq OMX Group Inc. in New York and Kansas City, Missouri-based Bats Global Markets, which operates BZX Exchange, told the SEC they supported a ban on the practice after withdrawing their versions of flash orders last year. They agreed with regulators that the orders created a “two-tiered market” that allowed some investors to receive information not publicly available to everyone.
Bats’ view that flash orders should be banned hasn’t changed, said Chris Isaacson, chief operating officer. Direct Edge’s initiative renames flash orders and doesn’t guarantee price improvement to investors, he said.
“We’re disappointed with the SEC’s lack of ruling on the topic,” Isaacson said. “We’re hopeful they will act.”
TD Ameritrade Holding Corp. has employed flash orders on Direct Edge for several years. While less than 1 percent of the discount broker’s orders sent to Direct Edge use the mechanism, “it helps lower execution costs while improving or matching the best available price,” said Christopher Nagy, managing director for order strategy at the Omaha, Nebraska-based company.
Flash orders on Direct Edge never amounted to more than 1 percent of overall market volume, according to spokesman Rafi Reguer. O’Brien said they currently account for a “relatively slight” portion of Direct Edge’s business. Its two exchanges traded 10.4 percent of U.S. equity volume in October, the highest level since May and the same as a year ago.
Direct Edge’s proposal resembles an auction system used in options market and “is a fair and transparent way to get price improvement to retail orders,” Nagy said.
The SEC reopened the public comment period for flash orders in July to solicit more information about how they’re used in options after the largest exchanges, market-making firms such as Chicago-based Citadel LLC, and retail brokers including TD Ameritrade argued that they benefit investors.
The Chicago Board Options Exchange and International Securities Exchange, which operate the largest venues for equity derivatives, told the SEC flash orders should be permitted in their industry. The Securities Industry and Financial Markets Association also said it supports the orders in options.
NYSE Euronext, which operates the New York Stock Exchange, argued in letters on Nov. 23, 2009, Aug. 9 and Oct. 29 that the SEC should eliminate flash orders. The company and Getco told the SEC that flashed orders can be abused by firms taking advantage of the information they contain and create a disincentive for market makers to provide quotes at the best prices since they may not lead to executions.
Direct Edge also plans to integrate its auction into what’s called its continuous order book, which comprises the buy and sell trading requests sent to the exchange for automatic execution. Six months after the SEC approves the company’s rule proposal, Direct Edge will enable orders sent to its platforms to interact with buy and sell interest participating in the auctions, the company said.
“We’re always mindful when submitting new proposals to do that in light of where regulations are heading,” O’Brien said about his market’s micro-auctions for stocks. “We feel these proposals are good business and good regulation.”
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