July 27, 2009 / 6:15 PM / 10 years ago

Direct Edge in crosshairs of "flash" orders debate

NEW YORK (Reuters) - The growing debate over “flash” orders, amplified late last week when a prominent U.S. senator weighed in, could spell trouble for Direct Edge, the fast-growing stock trading venue that has the most to lose if they are banned.

William O'Brien, Chief Executive Officer of Direct Edge, speaks at the Exchanges and Trading Summit in New York May 11, 2009. REUTERS/Eric Thayer

Rival exchanges, some of whom also offer flashes, have been coy on whether they support the service and may quietly hope they are eliminated for good.

Direct Edge was the first to start “flashing” customer orders — for fractions of a second — to certain market members before routing them elsewhere to all participants.

The practice gives banks, hedge funds, and some dark pools, where orders are matched anonymously, an advanced look at order flow. The service helped spark Direct Edge’s impressive growth, and was closely imitated early last month by formal exchanges Nasdaq Stock Market and BATS Exchange.

Direct Edge, which now has about 12 percent of U.S. equity market share, is center stage in defending flashes as an optional service that provides liquidity to those who otherwise wouldn’t have it, and as a natural evolution of competition among exchanges for trading volumes.

Critics, including Sen. Charles Schumer, who threatened July 24 to ban flashes, say they provide an unfair advantage to select participants, creating a “two-tiered” market that undermines the confidence of those without lightning-quick computer trading software.

“It’s very important” for Direct Edge,” said Patrick O’Shaughnessy, analyst at Raymond James and Associates. “It’s far and away the most profitable component of their trading volume ... and if that were to be eliminated it would have a serious negative financial impact on the firm.”

Direct Edge, which aims to become a formal exchange operator later in 2009, has more than tripled its market share in the last year, thanks in large part to its flash program, called the Enhanced Liquidity Provider, or ELP.

Although ELP accounts for only about 10 percent of Direct Edge’s overall volume, it brings in the lion’s share of revenues, allowing the consortium-owned company to aggressively battle Nasdaq OMX, NYSE Euronext, and BATS on pricing in the transparent market.

“The ELP has been a really effective competitive weapon for Direct Edge against the established exchanges,” said Justin Schack, vice president of market structure analysis at agency broker Rosenblatt Securities.

While the Big Board has lobbied hard against flashes on the grounds they harm investors, Nasdaq and BATS introduced similar services June 3 that exposed flashes to a far larger group of market participants than the approximately 30 at Direct Edge, which is based in Jersey City, New Jersey.

BATS’ market share has since risen more than 1 percent.

But Kansas City-based BATS, which is also consortium-owned and has 11 percent market share, is “ready to participate in an industry review of potential issues associated with (flashes), including the possibility that they create a two-tier market,” CEO Joe Ratterman said in a monthly newsletter.

Nasdaq, whose market share skidded even more than the NYSE’s so far this year, did not immediately comment on Schumer’s letter to the U.S. Securities and Exchange Commission. An executive told Reuters last month Nasdaq wants “a level playing field.

“Nasdaq and BATS came out with their own versions of this because they felt like they had no other choice,” Schack said.

“They aren’t crazy about doing this, maybe it doesn’t feel 100 percent right for them, but they feel like ELP was so effective as a competitive weapon that they had to do something to fight back.

“If the SEC decided tomorrow that you couldn’t use any kind of flash functionality, they might not be really opposed to that,” he said.

Schumer, a senior Democrat on the Senate Banking panel, warned SEC Chairman Mary Schapiro in a letter that if the regulator doesn’t eliminate flashes, he would introduce legislation that does.

Schapiro has said that she is concerned about the growth of dark pools — the dozens of private venues where flashes often go — and that the SEC may take action.

Direct Edge CEO William O’Brien said in an interview July 24 the intervention of Congress in issues of micro market structure would “set a very bad precedent.

“The SEC has done a wonderful job in managing the balance of conflicting objectives of the national market system,” O’Brien said. “They are generally best equipped to deal with how to successfully manage that balance of interest.”

Direct Edge is owned by Goldman Sachs, JPMorgan Chase & Co, hedge fund Citadel, Knight Capital Group, and the International Securities Exchange, a unit of Deutsche Boerse’s Eurex exchange.

Reporting by Jonathan Spicer; Editing by Phil Berlowitz

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