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Introduction
In response to an outcry of criticism voiced by the public, Congress and regulators, on September 18, 2009, the Securities and Exchange Commission (the “SEC”) proposed to ban the use of “flash orders” on equities and options exchanges and large alternative trading systems (Exchange Act Release No. 34-60684 (September 18, 2009)).
The term “flash orders” refers to a practice whereby a trading center will for a few milliseconds show subscribers of the trading center’s data feed customer buy orders priced at the national best offer, or customer sell orders priced at the national best bid. Market participants with fast electronic connections can then execute the orders at the flash price. If the order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed to other exchanges.
The SEC is concerned that although flash orders provide customers with better prices, they harm the markets for long-term investors by undermining public quotes and creating a two-tier market. Under the proposal, flash orders would be impermissible “locking quotes”, i.e., quotes that “lock the market” by matching the quote on the opposite side of the best bid and offer. The SEC states in the release that certain market mechanisms and order types, such as price improvement auctions and immediate or cancel orders (“IOCs”), that bear some functional similarities to flash orders will not be affected by the proposal.
Perhaps more significant than the proposed ban of flash orders is the signal that the SEC is once again preparing to intervene in the equities and options markets. The SEC stated its intention to consider in the near future additional market structure topics, including dark pools, Regulation ATS thresholds, alternative trading systems (“ATSs”) post-trade transparency, direct market access, high frequency trading, and co-location, either through proposals or concept releases.
Brief Description and History of Flash Orders
Flash orders are commonly used to send customer buy orders priced at the national best offer, or sell orders priced at the national best bid, to trading centers that may not be displaying the national best quote. The flash order offers the potential for the order to trade on the preferred trading venue immediately at the best price publicly quoted in the market without having the order routed to another market, and for market participants receiving the flashed order information to trade against the order without having to publicly quote the best price.
Because exchanges and other trading centers benefit from maximizing the number of orders that are executed on their markets, they are often willing to pay rebates to brokers who send flash orders that are executed on their markets. The brokers might otherwise have to pay fees to a destination market if the flash orders are routed away and executed there.
The practice of electronically “flashing” orders to a select group of market participants began in the options market in 2004, and is now used on a number of options exchanges. It spread to the equities markets in 2006, first on the CBOE Stock Exchange to avoid the delay of routing Chicago-based orders 700 miles east for potential execution.
Direct Edge’s ATS introduced its flash order type (called “ELP”) in June 2006, followed three years later by BATS and Nasdaq.
Even though flash orders had been used by floor brokers on exchange trading floors for many years, and are similar to over-the-counter internalization practices, in August 2009, flash orders flared into public view as a part of the attention directed at high frequency trading. In the wake of public criticism, Nasdaq and BATS announced that they would voluntarily shut down their respective flash order systems on September 1, 2009.
The SEC’s proposal has become the next chapter in this story.
The Proposal
Proposed Amendment of the “Quote Rule” of Regulation NMS
The SEC proposes to eliminate paragraph (a)(1)(i)(A) of Rule 602 of Regulation NMS, which today excludes from the requirement to display quotes “[a]ny bid or offer executed immediately after communication and any bid or offer communicated by a responsible broker or dealer other than an exchange market maker which is cancelled or withdrawn if not executed immediately after communication.” As a result, flash orders on an exchange would need to be included in the exchange’s public quote.
The SEC explains that other trading services similar to flash orders would not be altered by the proposal. In particular, the SEC cites exchange price improvement auctions such as the Boston Options Exchange’s Price Improvement Mechanism, the CBOE’s Simple Auction Liaison, and the ISE’s Facilitation Mechanism as trading services that would be permissible even if the proposal is adopted. The SEC reasons that “a competitive auction that provides an opportunity to obtain better prices than displayed quotations would not constitute bids and offers . . . nor would the responses to those orders if they were actionable only with respect to the exposed order.” In addition, as previously noted, IOCs would not be covered by the amendment to Rule 602, because they are taking liquidity, not offering liquidity.
The SEC requested comment on numerous issues relating to the Rule 602 amendment, including:
- whether trading floors should be permitted to continue manual “flashing” of orders if electronic “flashing” is prohibited and what, if any, conditions should apply;
- whether there should be a distinction in approach between listed options and cash equities; and
- whether requiring broader dissemination of flashed order information, such as in the consolidated quote stream, or providing flash order information free of charge to anyone, would address concerns about a two-tiered market.
Proposed Interpretation of Locked and Crossed Market Requirements
Rule 610(d) of Regulation NMS requires national securities exchanges and associations to establish, maintain and enforce rules to reasonably avoid displaying “locking” or “crossing” quotations. If the amendment to Rule 602 is adopted, the SEC would consider the display of quotations that either are immediately executed or withdrawn if not immediately executed to be the display of quotations that are subject to Rule 610(d).
Therefore, orders with marketable prices could not be flashed without being a locking or crossing order subject to Rule 610(d).
The SEC would also adopt an interpretation of the locked and crossed markets provisions of the Linkage Plan for options that would have a similar result in the case of flash orders for listed options.
Proposed Display Requirements for Flash Orders on Alternative Trading Systems
An ATS is a market center that is exempted from exchange registration conditioned on being registered as a broker-dealer and complying with certain essential elements of exchange regulation. An ATS that achieves certain threshold levels of trading activity in individual securities is subject to further requirements relating to fair access and display of quotations. Rule 301(b)(3)(ii) of Regulation ATS provides that if an ATS meets a 5% volume threshold in an exchange-traded stock, it must submit its quotes in such stock to be included in the consolidated quote stream. The proposal would apply Rule 301(b)(3)(ii) to orders that either are immediately executed or withdrawn if not immediately executed, and that would otherwise be included in the quote stream under Rule 301(b).
Therefore, an ATS would be required to send to the consolidated quote stream flash orders for stocks that the ATS is required to quote publicly.
The SEC addressed the use of indications of interest (“IOIs”) in the ATS context, stating that “[Flash] orders would be covered regardless of the particular term that an ATS might use to characterize the order, such as ‘indication of interest.’” The SEC also cited the Regulation ATS adopting release discussion regarding IOIs: “The label put on an order – ‘firm’ or ‘not firm’ – is not dispositive. For example a system claiming it displays only ‘indications of interest’ that are not orders, may be covered by the new interpretation of ‘exchange’ if those indications are, in fact, firm in practice.” Presumably the SEC’s approach would apply to the use of IOIs in all contexts.
Conclusion
The SEC released a broad proposal to eliminate flash orders across equity and options markets, and manual and electronic trading centers. The proposal, if adopted, would require significant changes to trading strategies and business models that are in place today at order entry firms and trading centers, and would also quell criticism from legislators and the public about the “two-tiered” effect of flash orders cited by the SEC.
The proposal has a 60-day comment period.
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