August 06, 2009

As the SEC contemplates banning flash orders altogether, the three major providers of flash-order services — Direct Edge, the BATS Exchange and Nasdaq OMX Group — have all adjusted their flash order services. BATS and Nasdaq have stopped offering them altogether; Direct Edge has dropped its plans to offer a type of flash or "flare" order that the company says is similar to the BATS and Nasdaq offerings.

Flash orders — ultra-brief sneak previews of orders that some traders (or more relevantly, their trading algos) can access — have been under contention since last Friday, when Senator Charles Schumer wrote a letter to SEC chairman Mary Schapiro suggesting that flash orders be banned. In the letter, Schumer specifically cited Direct Edge's Enhanced Liquidity Program, NASDAQ's Flash order program and BATS's Bolt Optional Liquidity Program. "Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity," he wrote. "While pre-routing programs can benefit markets by providing additional liquidity, 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, depriving others of a fair price for their transactions. If allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets."

BATS and Nasdaq both announced yesterday that they would withdraw from flash orders; Direct Edge announced this morning its backing away from similar "flare" orders. However, under its Enhanced Liquidity Provider program, it will still allow customers to "flash" a price to ELP members, in hopes of a price or size improvement. The organization says it does not allow any locking mechanism that would disadvantage other traders.

In its statement, Direct Edge said that although customers see price and size improvements from its Enhanced Liquidity Provider program, "we also recognize that the SEC has commenced an overall review of market structure in which certain order types are a component. Accordingly, Direct Edge has suspended its plan to offer flash functionality (tentatively entitled the "Flare" order) similar to that previously introduced by NASDAQ and BATS, voluntarily withdrawing a related rule filing with the SEC."

In a memo issued Wednesday to clients, Direct Edge CEO William O'Brien defended the company's existing flash order service. "While a small portion of our business, ELP functionality is an important choice for many of our customers, including certain customers handling retail order flow," he said. "To discreetly ban or eliminate ELP functionality without any other market structure changes would simply deny brokers and investors access to liquidity they previously enjoyed, with no realistic alternatives available to them."

Direct Edge customers, he said, achieve superior execution quality and lower transaction costs through use of ELP. "While ELP-eligible order types are not right for everyone, no one has offered any hard evidence that usage of such orders by a broker or investor is causing quantifiable harm to themselves, anyone else, or the system as a whole," he said. "Every Direct Edge customer who uses the program chooses to do so, and any customer who wishes to be an ELP can do so. That choice levels the playing field, and we believe that brokers are best equipped to decide when participation is appropriate."

BATS Exchange executives say they began an industry review of flash orders on July 7th and identified concerns with the practice. "The driver behind our review, which was well before Sen. Schumer raised the issue, was the fact that we don't believe it to be good, sound market structure," says Randy Williams, vice president of BATS.

"The move announced by BATS Exchange today reflects our commitment to doing what we can to make markets better and it is our hope that, through serious discussion, a rational conclusion can be made as to whether these order types are detrimental to the markets and should be prohibited going forward," said Joe Ratterman, CEO of BATS Exchange and BATS Global Markets in a statement yesterday.

In Nasdaq's statement, the exchange said, "We appreciate that Chairman Schapiro and the Commissioners will assume overall leadership for the industry to conduct a comprehensive review of all issues related to flash orders. We recognize the SEC's rulemaking process will take time, yet as an exchange we have the ability to move on our own."

ABOUT THE AUTHOR