Exchanges' anonymous trading sets off alarms

By Jonathan Spicer

NEW YORK (Reuters) - Recent moves by exchanges to dabble in anonymous stock trading is tripping yet another alarm for U.S. regulators and amplifying a debate over fair markets.

There could be serious implications for the way orders circulate through capital markets if the moves, which reflect exchanges' intense competition for market share, provoke a response from securities regulators.

The U.S. Securities and Exchange Commission has already received at least three letters of complaint, including one from the Securities Industry and Financial Markets Association, warning of a market that benefits a privileged few while distorting the prices of public stocks.

The SEC said it has not yet decided whether to act.

At issue are so called "flash" orders -- buy and sell orders the Nasdaq Stock Market and BATS Exchange this month began sending to a private group of select market participants before routing them to rival venues. The service closely mirrors one long offered by fast-growing alternative venue Direct Edge.

The flashes, an optional service, also alert some "dark pools" -- non-displayed, private venues that anonymously match orders, allowing traders to hide their intentions.

Flashes, although not a top priority for regulators, are unlikely to survive completely unfettered, given the financial crisis is ushering in sweeping changes intended to make markets more transparent and participants more accountable.

"One of the things we should have learned in the last 24 to 36 months is that innovation in the financial services industry is not necessarily in the best interest of the average investor," said Richard Gates, portfolio manager of TFS Capital's $620 million market mutual fund.

Direct Edge's flash program, called the Enhanced Liquidity Provider (ELP), matched an average of 171.45 million shares per day last month, only about 1 percent of the overall U.S. market.

But the privately-owned venue more than tripled its market share in the last year, forcing exchanges to react. Nasdaq OMX launched its FLASH program and BATS its BOLT program on June 5. Rather than follow suit, New York Stock Exchange parent NYSE Euronext urged the SEC to halt the programs on grounds they harm markets and investors.

In another letter to the SEC, Direct Edge defended ELP, FLASH and BOLT as innovative and beneficial to customers who pay lower trading fees and enjoy better liquidity -- arguments that were later countered by letters from market-maker GETCO and financial industry group SIFMA.

SIFMA charged that Nasdaq did not provide enough time for member firms to make necessary changes in order routing systems, nor enough time to debate the controversial issues it raised, such as price transparency and the creation of a "two-tiered market" that could hurt investor confidence.

"Exchanges should not be permitted to put firms in the difficult position of potentially being out of regulatory compliance in order to advance their own commercial, competitive agendas," SIFMA said in its June 4 letter.

SECOND CHANCE TO MATCH ORDERS

A flash order that isn't immediately filled on a trading venue is sent to a network of dark pools, broker-dealers and other market makers, who can fill it anonymously before it is sent elsewhere to be matched at the best available price.