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Exchanges' anonymous trading sets off alarms
June 15, 2009 / 4:16 PM / in 8 years

Exchanges' anonymous trading sets off alarms

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.


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.

Flashes effectively give the host venue a second chance to match orders in-house, denying rivals lucrative order flow from an increasingly automated crowd of traders.

The SEC -- which is bogged down with fraud cases and a short sale debate, among other high-profile issues -- has 60 days to revoke FLASH and BOLT, whose applications were filed in a way that allowed them to launch immediately. Because the SEC has been quiet so far, it very likely sees the programs as legal.

But SEC staff are looking closely at the flash debate in the wider context of dark pools, which have proliferated in the last few years in response to Regulation NMS and other rules meant to connect and speed up markets, and improve prices.

James Brigagliano, co-acting director of the SEC’s trading and markets division, said in a speech last month he would be concerned if dark pools hamper price discovery and worsen volatility. But he added that there was so far little evidence of this and that no decision had been made on whether to act.

“You get the feeling when trading that you’re not seeing the whole picture,” said Bernie McSherry, senior vice president at institutional broker Cuttone & Co.

“You’ve got lots of hidden liquidity, you’ve got orders that are being exposed preferentially to some participants and not others, and I think that just works against an efficient market,” he said. “It’s not a good development.”

The SEC is unlikely to clamp down hard on flash programs, but it could temporarily halt them, require more details on them, or modify their rules.

The flashes -- which harken back to last decade, when exchanges gave their floor members an early look -- could also spark a reevaluation of the so-called quote rule exception, which at times allows market makers to trade at better prices in alternative venues without publishing an improved quote.

“The SEC tends to be very timid in their regulatory purview,” said James Angel, associate professor of finance at Georgetown University’s McDonough School of Business.

“The problem the SEC has is that they have real trouble keeping up with the changes in market structure.”

Reporting by Jonathan Spicer; editing by John Wallace

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