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Flash Order Debate Moves to Options After Direct Edge Bows Out

The U.S. options market has become one of the last arenas for flash orders after Direct Edge Holdings LLC, the third-biggest equity exchange, said it would no longer allow the split-second requests to buy or sell stocks.

Flash trades generated controversy in July 2009 after Senator Charles Schumer, a New York Democrat, said the practice gave some investors an unfair advantage. The U.S. Securities and Exchange Commission proposed banning them two months later. Opposition from CBOE Holdings Inc., International Securities Exchange and market-maker Citadel LLC has delayed the rule.

Calls in Congress to bar flash orders 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 indicated in November it was altering the way it handled the trades, said last week it would drop them following an SEC decision to review its changes.

“This decision is consistent with our long-standing position that we would abide by the SEC’s rulemaking on this topic, and we believe that now is the appropriate time to be proactive and cease offering” the orders, Direct Edge Chief Operating Officer Bryan Harkins said in an e-mailed statement.

Flashing allows venues to match orders by soliciting trading responses from users instead of sending buy or sell requests that they can’t fill to rivals quoting better prices. TD Ameritrade Holding Corp., which supported Direct Edge’s flash mechanism, has said it benefits investors by allowing them to execute larger orders faster or at better prices.

Market Share

Executions from Direct Edge’s flash orders represented 2.3 percent of the company’s share of trading last month through Feb. 25. They accounted for 0.3 percent of total U.S. equities volume. Direct Edge was the third-largest equities exchange operator in January.

CBOE Stock Exchange, which has offered flash orders since it began trading stocks in March 2007, has no plans to stop them, Gail Osten, a CBOE spokeswoman, said in an e-mail.

Nasdaq Stock Market in New York and Kansas City, Missouri-based Bats Global Markets in June 2009 began offering similar orders to compete with Direct Edge, which was gaining market share. Both halted the order types at the end of August 2009 after NYSE Euronext, Getco LLC and politicians pushed the SEC to ban the trading requests.

“The practice of flash orders ending on the cash equities side was inevitable,” said Sang Lee, co-founder and managing partner at Boston-based research firm Aite Group LLC. He added that he’s “a bit surprised the SEC has not officially banned flash orders since that’s the easiest way to tackle the issue.”

Step Up

CBOE and ISE have argued that eliminating flashes in options, where they’re called step-up orders, will constrain their ability to compete with NYSE Arca and other exchanges that match buy and sell requests based on different standards than they use. Unlike in equities, options venues don’t use the same rules for handling buy and sell orders. Some exchanges guarantee market makers quoting at the best price a certain portion of incoming orders while others give the executions to the first in line at a specified price.

Opposition from exchanges and brokers against a ban in options remains strong, Lee said. The SEC will eventually have to address the issue in options, he said.

CBOE said on Dec. 3 it flashes about 1 percent of buy and sell contracts that can be executed immediately to users.

Self Serving

“CBOE’s electronic step-up process has been in place since early 2006,” the exchange operator told the SEC. “Self-serving criticisms of flash processes surfaced over three years later. Without offering any evidence of harm, these critics posture that step-up processes are suddenly ruining our national market system.” The letter said that exchanges supporting a ban on flash orders have pursued “regulatory intervention that is favorable to their market models.”

NYSE Euronext told the SEC on Oct. 29 that flash orders in options are a disincentive to market makers to post limit orders because they’re less likely to get the executions they seek. It said the practice is “anti-competitive.”

Nine exchanges compete to trade options in an industry where volume rose to 3.9 billion contracts last year for an eighth straight annual record, according to the Options Clearing Corp. The largest is CBOE, followed by Nasdaq OMX PHLX and ISE. The ISE is owned in part by Deutsche Boerse AG, which said on Feb. 15 it would combine with NYSE Euronext to form the world’s largest operator of securities and futures markets. Nasdaq OMX Group Inc. is based in New York.

Options Debate

The debate in options about step-up trades may relate to a discussion about how much exchanges can charge users in trading fees, the SEC said. That’s because a venue might be incentivized to keep orders on its market in order to protect brokerages it serves from charges elsewhere. The SEC reopened the public comment period for flash orders in July to generate discussion about the relationship between flash orders and fees, it said.

Regulators in April proposed to limit fees for trading options on exchanges, a move supported by Citadel LLC, which makes markets on options exchanges and supports the use of step-up orders. Citadel and others have argued that the lack of a cap in options could allow exchanges to levy higher transaction fees that distort the overall price brokers pay for trades. For many products, CBOE and ISE don’t charge brokers for customer orders. NYSE Arca Options charges anyone who executes against orders it holds while paying firms providing bids and offers.

Fee Caps

CBOE Holdings, which owns CBSX with a group of brokers, urged the SEC not to impose fee caps. Fee caps could affect the exchange’s ability to charge for options on the Standard & Poor’s 500 Index, which it has an exclusive license to trade. CBOE officials have held meetings with SEC commissioners to discuss the rule in May, July, September, November and January.

Aite’s Lee said that while flash orders in equities served a purpose for investors that used them, they became a symbol for a larger spate of controversial stock trading issues.

“Flash orders ignited the whole discussion around market structure issues in equities including high-frequency trading and dark pools -- that was the tipping point,” he said. “With all the brouhaha, a lot of people assumed there’d be quick changes, so this is anti-climactic in terms of the practice disappearing. Most exchanges just came to the conclusion it’s not worth pushing at this point.”

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