Some observers see Securities & Exchange Commission Chairwoman Mary Schapiro's announcement on Aug. 4 that the SEC will seek to ban ultra-high-speed stock trades—which give institutional traders a big edge over retail investors—primarily as an issue of competition between traditional and alternative trading platforms.
But there's reason to believe the SEC's move is, at least in part, motivated by bureaucratic survival instinct. Schapiro's announcement came within a week of a private meeting on July 31 in which Treasury Secretary Timothy Geithner reportedly lambasted top regulators for their criticism of aspects of the Obama Administration's proposed overhaul of U.S. financial regulations. It may well be that, amid general resistance to cede some of their authority to a new consumer protection agency that President Obama wants to create, regulators such as Schapiro are eager to demonstrate their relevance and ability to get things done.
The ultra-high speed trades, known as flash orders, give a group of high-frequency traders a millisecond-ahead peek at buy or sell orders before they get routed to the entire market to be filled. The concern is that they give an unfair advantage to a only the handful of investors with access to the very expensive technology that allows this.
Until recently, Direct Edge ECN had been one of just two electronic exchanges (the other is CBSX, the Chicago Board Options Exchange's stock market, which has very small daily volume) that offered flash orders. The Nasdaq Stock Market (NDAQ) and BATS Exchange started offering the feature in early June, but on Aug. 6 both exchanges said they will no longer offer them as of Sept. 1. BATS, in a July 7th newsletter, outlined possible inequities around the use of flash orders and said it would be willing to take part in an industry review of these issues before telling its customers and other trading community members in a separate letter at the end of July that it would support a ban on flash orders based on those rational concerns. Nasdaq Chief Executive Robert Greifeld, in a July 27 letter to Schapiro, cited concerns about the securities industry's apparent "willing[ness] to accept more and more 'darkness' and limits on the availability of order information," and had recommended eliminating any type of order or market structure that doesn't contribute to public price information and market transparency.
more philosophical than practical?"I don't think either one of them really intended to use it as a competitive advantage," says Patrick O'Shaughnessy, an analyst at Raymond James Equity Research in Chicago. "Given all the hubbub, they figured it wasn't worth it. They thought that ultimately Direct Edge would have to get rid of it, so they may as well kill it now and be seen as ahead of the curve."
Sang Lee, managing partner at Aite Group, an independent research firm in Boston, sees the debate about flash orders as more philosophical than practical. Since the total market volume that goes through flash orders accounts for only 2% to 3% of daily volume, he says, there would not be a big change in trade volume among major players if those orders disappeared.
"The only change is that philosophically, perhaps, this is creating a separate market," Lee adds. "I don't think they have proof it's hurting investors in the stock market."
The pace of trading has increased so dramatically that it's worth asking whether regulators have lost the ability to keep up, says Bill Cline, chief executive of Acai Solutions, a capital markets consulting firm in New York. With equity trading volume dispersed over a larger number of trading venues and more rigorous mandates such as Regulation NMS in the U.S.—the initiatives adopted by the SEC in 2005 requiring that all trading venues ensure the best execution of trades—there's much more competition for order flow than there was just five years ago. "I think it's good as long as there's a level playing field," says Cline.
concerns about "Dark Pools"It's not clear how market liquidity would be affected if the SEC enacts a broader plan to address what Schapiro calls "the potential investor protection and market integrity concerns" raised by "dark pools." These are private alternative trading platforms that enable institutional investors to match big-block trading orders with minimal, if any, impact on market prices.
The impact of any increased oversight of dark pools will depend on what the regulations look like, says Fred Lipman, a partner at law firm Blank Rome in Philadelphia. "It may be nothing more than [requiring] more disclosure by dark pools," he says. "Sometimes when you require information about how they operate, it affects the way they operate, because they don't want to look bad."
But Lipman doesn't see any regulatory crackdown diminishing the competitive advantage dark pools enjoy as private trading platforms.
Cline at Acai doesn't believe a ban on flash orders is inevitable. If flash orders are popular with traders and contribute to their positioning, he says, they should be allowed in a competitive market. Given the high costs to install infrastructure that can provide those last few milliseconds of advantage, the only players willing to invest in such technology are high-frequency, algorithmic trading firms—the large hedge funds that try to take advantage of time and price-arbitrage between different markets, he says. And given that flash orders are a small a part of overall U.S. equity-trading activity, he doesn't believe they put the majority of investors at much of a disadvantage. perception of advantageIt's hard to determine what part a letter to Schapiro from Senator Charles Schumer (D-N.Y.) dated July 27 played in the SEC's crackdown on flash orders. In the letter, Schumer shared his concern about exchange members benefiting from flash trades by using "rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity." Although it's worth noting that the New York Stock Exchange (NYX) is one of Schumer's key constituents, he may just be "reacting to what he views as an unfair trading system," says Lipman.
It's important to distinguish the kind of "information leakage" Schumer referred to from "front-running," where brokers trade ahead of a client who has placed an order, says O'Shaughnessy at Raymond James. There probably are a certain number of flash orders that result in information leakage, which causes the traders behind the original orders to get worse price execution than they otherwise would get, he says. But many flash orders result in better price execution, he adds. Even if actual leakage is fairly infrequent, the public perception that flash orders give traders the ability to get better price execution may be just as important if it's prompting people to switch from traditional exchanges to alternative platforms that can offer their members that advantage, says Lipman. That may be one reason Direct Edge's market share has jumped to 12% in July from 5% a year earlier.
Nasdaq CEO Greifeld's letter to the SEC may reflect concerns about how much competitors such as Direct Edge, which began offering flash orders three years ago, have already benefited from these orders, says Cline. "If you're a traditional exchange and you're looking to fend off this competition, then getting a practice banned that has benefited your competitors more than you is a good thing," he says.
Regardless of the endgame, there will always be differences in the speed of information-technology capabilities of market centers and market participants, says Cline. As long as market centers compete for order flow, that would seem to benefit investors, even if they participate only through investments in mutual or pension funds, he says. Large institutional investors benefit directly by having enough liquidity to move a big block of shares with minimal price impact. "Ultimately, who does that benefit?" asks Cline. "I think you and me."