Squabble over trading heats up with SEC letters

NEW YORK (Reuters) - A dispute over how U.S. trading venues handle orders heated up this week as fast-growing alternative venue Direct Edge slammed a letter the New York Stock Exchange sent regulators, in a case that weighs whether competition and a fragmented market help investors.

The controversy centers on a Direct Edge product that allows a specific group of market participants to match buy and sell orders from the customers before they are routed to an exchange or another alternative venue.

Nasdaq Stock Market parent Nasdaq OMX and BATS Exchange, the other players in the country's cut-throat trading industry, recently applied to the Securities and Exchange Commission to offer similar products. Direct Edge, the No. 3 U.S. equities-trading venue, has made big market share gains in recent months.

Big Board parent NYSE Euronext, which retains the biggest market share, last week urged the SEC to reject the Nasdaq and BATS filings on the grounds it "impedes a free and open market system and harms the investing public."

NYSE Euronext's May 28 letter also highlighted Direct Edge's product, called the Enhanced Liquidity Provider (ELP), asking the market regulator to "undertake a market-wide review of the impact of such pre-routing display functionality."

On Wednesday, Direct Edge said in a letter to the SEC that NYSE Euronext's comments are "factually inaccurate, are logically inconsistent, and contradict their own market structures, prior policy statements, and marketing materials."

Direct Edge, which is not yet an exchange but last month matched 12.6 percent of U.S. stock trades, said its ELP product, as well as Nasdaq's and BATS' proposals, "are part of a broader strategic competitive battle regarding the liquidity-aggregation and other innovative products offered to their customers."

The private venue -- owned by International Securities Exchange, Goldman Sachs, JPMorgan, Knight Capital Group and Citadel -- said its optional program reduces transaction costs and improves trading executions.

In its nine-page letter addressed to SEC Secretary Elizabeth Murphy, Direct Edge also urged the SEC to approve the applications from Nasdaq and BATS.

The ELP program has helped Direct Edge more than triple its market share in less than a year. A crackdown on these types of programs could severely crimp the company's growth and revamp the market share of U.S. exchanges.

RULES REVISITED?

The dispute highlights the intense competition among exchanges and alternative venues to attract the lucrative, high-speed order flow from increasingly automated traders.

In the last few years, new U.S. rules, called Regulation NMS, forced exchanges and other venues to route orders to where they will receive the best possible price, stoking competition and sparking an explosion in alternative venues.

"Our issue is whether the spirit of what is happening right now either isn't consistent with the intent of Reg NMS, or whether the evolution of competition has got to a point where the public market is not being helped by a lot of these practices," Joseph Mecane, NYSE Euronext's executive vice president of U.S. cash markets, told Reuters on Thursday.

"It's not a positive trend," Mecane said on the sidelines of an industry conference hosted by Sandler O'Neill here, adding the company is debating whether to file another letter to the SEC to clarify its position.

Earlier on Thursday, BATS Chief Executive Joe Ratterman told the conference: "We are convinced that the SEC will deem all of these ... programs as legal," referring to its BOLT program, Nasdaq's FLASH program, and Direct Edge's ELP.

Brian Hyndman, Nasdaq OMX's senior vice president of transaction services, told Reuters the exchange wants "a level playing field," adding he thanked Direct Edge for its letter of support.

The letters to the SEC come within weeks of a clash on a New York conference panel between NYSE Euronext Executive Vice President Larry Leibowitz and Direct Edge Chief Executive William O'Brien on the topic.

Before a large industry crowd, Leibowitz suggested Direct Edge's ELP program created a two-tiered market that would hurt price transparency and further fragment the market. O'Brien defended the program, adding the NYSE "has more tiers than Yankee Stadium."

(Reporting by Jonathan Spicer, editing by Dave Zimmerman and Steve Orlofsky)