MANHATTAN (CN) – The SEC on Thursday unanimously proposed a ban on “flash orders” – an increasingly popular feature of high-frequency trading that allows certain traders to see orders up to a second before the public can trade them. “If you are deliberately delaying orders by one second, that seems to be a very significant penalty on the order, given the speed of the market today,” said Joel Hasbrouck of the NYU Stern School of Business.
Market traders with the instantaneous head-start can “flash orders and avoid the need to make the order publicly available,” putting them at a distinct advantage compared to those who can only access public quotes.
Flash orders are currently exempt from rule 602 of Regulation NMS, but the SEC says that exception may no longer “necessary or appropriate in today’s highly automated trading environment.”
“Flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities,” SEC Chairman Mary Schapiro said in a statement.
According to the SEC, a flash order delay lasts less than a second, but Hasbrouck says the difference is nothing to blink at.
“We might argue that a delay of 5 or 10 milliseconds is immaterial,” says Hasbrouck, who is the Kenneth G. Langone professor of business administration at Stern. “But if you are deliberately delaying orders by one second, that seems to be a very significant penalty on the order given the speed of the market today.”
In 2006 a small firm called Direct Edge Holdings became one of the first companies to adopt the practice, which uses advanced computers to buy and sell thousands of shares from one moment to the next. With the promise to subscribers of meeting ideal price and volume targets, Direct Edge rose in 2009 to become the third largest equities marketplace.
If the ban comes into effect, Direct Edge will not necessarily lose the upper hand.
“In the world of electronic trading, attracting market share and success to your market can turn on very tiny advantages in speed,” Hasbrouck says. “Even if flash orders are banned and Direct Edge were to offer everybody the same speed it just might be the case that they are still the faster market and would still be successful.”
Hasbrouck says that while banning flash orders will not create a perfectly level playing field for investors, it will remove some of the less natural practices companies have been using to gain an advantage.
Investors can face random delays that play upon distance from the market or computer speed, but Hasbrouck is troubled by the introduction of a calculated interruption that flash orders create.
“When the delay becomes not something that is random and inevitable, but something that becomes systematically introduced – that, to my way of thinking, crosses a line,” he says. “There will be faster computers or people who can think more quickly and react first. I do draw the line where this is a deliberate delay introduced.”
Another factor that contributes to the inequality of flash orders is that the practice relies on traders paying hedge funds with the best computers, Hasbrouck says. The professor also disclosed that he teaches classes on financial markets to hedge funds – some of which may engage in flash trading – but he does not consult on their trading practices.
Eliminating the flash order exception would affect equity exchanges, options exchanges, alternative trading systems and all other markets, according to the SEC.
The Commission is taking public comment on the issue, including whether it should differently evaluate the use of flash orders in the options markets and the equity markets, for 60 days following the publication of the proposal in the Federal Register.