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Perlow, Peery and Rosenblum on Regulators Focus on Flash Orders, Indicators of Interest, Dark Pools and Co-location

The United States Securities and Exchange Commission (SEC) has announced that it will examine and reconsider the legality of "flash orders," a market practice that is associated with high-frequency trading (HFT), as part of a larger review of market practices related to "dark liquidity," including "dark pools." This commentary discusses how the U.S. stock market has become the subject of a public controversy in a way that is rare for securities market structure issues. The authors write that the SEC, prompted by this publicity and a letter from U.S. Senator Charles E. Schumer (D-NY), has announced that it will examine and reconsider the legality of flash orders, a market practice that is associated with HFT,as part of a larger review of market practices related to dark liquidity, including dark pools.
On July 24, 2009, Senator Schumer requested that the SEC act to prohibit flash orders, arguing that this practice allows certain traders to obtain order flow information for computer-based trading before the information is routed to the broader public market. According to the Senator, these trading practices seriously compromise the integrity of markets and create a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions. If these practices are allowed to continue, they will undermine the confidence of ordinary investors and drive them away from our capital markets, according to the Senator. If the SEC fails to curb this practice, the Senator will introduce legislation that prohibits the use of flash orders in connection with optional pre-routing programs in order to ensure that trading in U.S. public capital markets is fair and transparent for all market participants. The SEC announced on July 30, 2009 that it is examining flash orders to ensure best execution and fair access to information for all investors. The SEC is now considering a ban of flash orders, according to reports on August 5, 2009.
Flash Orders and Flash Trades
The flash order, also referred to in industry parlance as a step up or pre-routing display order, works as follows: when a trader submits a limit order to buy or sell securities to certain market centers, the market center flashes or transmits the order immediately to certain traders a fraction of a second before the market center displays the order to the rest of the market; the traders pay the market center for this service and may receive a rebate if offered by the market center for completing the trade. Flash quoting programs display flash orders for typically 30 milliseconds or less, and sometimes as long as 500 milliseconds, the equivalent of a half of a second. Currently, two exchanges NASDAQ OMX Group Inc. (NASDAQ OMX) and Bats Global Markets (BATS) and one electronic communications network Direct Edge Holdings LLC (Direct Edge), which has applied to the SEC to become an exchange offer flash orders.
Where Are the Regulators Going?

No rule or regulation prohibits flash orders and trades, co-location or dark pools. Dark pools are alternative trading systems that operate under Regulation ATS, which exempts them from many requirements that apply to exchanges to the extent that the applicable stocks do not cross certain volume thresholds, and the Quote Rule and the Display Rule under Regulation National Market System (or NMS) under the Securities Exchange Act of 1934 do not apply to dark pools. The SEC staff is currently considering requirements that would mandate disclosure of post-trade information that identifies dark pool operators and the trades that they execute, thereby making public dark pool liquidity and depth, according to an August 5, 2009 report. Whether the SEC would require real time or delayed disclosure is not clear at this point.
How Should Market Participants Respond?

As regulators examine the trading practices described here, market participants and those who serve or supervise them need to be aware of the issues that are implicated in the SEC examination of flash orders and related practices:

  • Best execution. Investment advisers and broker-dealers that send trades to market centers that offer (or don't offer) flash orders need to consider whether in doing so they are seeking best execution for their clients or customers;
  • Trading Strategies. Traders that engage in quantitative and other trading strategies in which speed and small price changes play important roles in those strategies should closely monitor developments and consider what effect, if any, proposed rule changes might have on those trading strategies …
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