* Schumer prepared to introduce legislation to ban flashes
* Warns of "two-tiered" system for "privileged group"
* Flashes alert exchange members to new orders (Adds Direct Edge CEO)
NEW YORK, July 24 (Reuters) - U.S. Senator Charles Schumer warned a top regulator on Friday that if she does not ban so-called "flashes" -- orders that stock exchanges send to a select group of traders before revealing them to the wider market -- he will introduce legislation that does.
In a letter dated Friday to Mary Schapiro, chairman of the U.S. Securities and Exchange Commission, Schumer said this type of order "seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment.
"If allowed to continue, these practices will undermine the confidence of ordinary investors and drive them away from our capital markets," Schumer, a senior Democrat on the Senate Banking panel, said in the letter obtained by Reuters and verified by an aide.
"If the SEC fails to curb this practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders," the letter said.
At issue are buy and sell orders that the Nasdaq Stock Market and BATS Exchange began "flashing" early last month to market members, including the big broker-dealers, before they are routed elsewhere to all participants.
The flashes -- which last for fractions of a second, allowing computer programs to respond -- are also available in some anonymous trading venues, known as "dark pools." Some describe them as exchange-run dark pools.
The new services at Nasdaq and BATS resemble one long offered by fast-growing trading venue Direct Edge, and amplified an ongoing debate over fair market access, prices, and the way orders circulate through the dozens of electronic trading venues in the United States.
Schapiro has not specifically mentioned flash orders publicly. But in a speech last month she raised concerns about the growth of dark pools, warning that the SEC may take action to protect market integrity and fair price discovery.
An SEC spokesman said he couldn't confirm or comment on letters the market watchdog receives.
The SEC has received at least five letters on flashes since May, when New York Stock Exchange parent NYSE Euronext NYX.N urged it to reject the flash applications from Nasdaq OMX (NDAQ.O) and BATS on the grounds the order type "impedes a free and open market system and harms the investing public."
The Securities Industry and Financial Markets Association (FINRA), Morgan Stanley (MS.N), and high-frequency trading firm GETCO also raised concerns with flashes in letters to the SEC.
Schumer's letter -- which named Direct Edge, Nasdaq and BATS -- said the flashes allow exchange members to use "rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity."
Defenders note that customers can opt out of having their orders flashed, and that the phenomenon is part of overall innovation in increasingly electronic markets where venues battle for market share.
Indeed, the NYSE told the SEC that if it does not clamp down on flashes, the exchange may have to offer a similar service so not to forfeit too much volume to rivals.
William O'Brien, CEO of Direct Edge, said in an interview flashes provide individual traders access to the liquidity they wouldn't have had in the bygone floor-trading era.
"Dark pools have always existed, whether it was a floor broker's pad, a specialist's book, or upstairs trading desk -- they've just become more automated now," O'Brien said.
"If you have Congress intervening in micro market structure issues on a discrete basis ... that's going to set a very bad precedent." (Reporting by Jonathan Spicer; Additional reporting by Thomas Ferraro and John Poirier in Washington; Editing by Andre Grenon, Gary Hill)