Financial Regulatory Forum

“Flash” trading controversy in U.S. raises issue of front-running

By Reuters Staff
August 7, 2009

NYSE-Euronext Executive Vice President Larry Liebowitz (l) (File photo) By Jonathan Spicer
NEW YORK, Aug 7 (Reuters) – With so-called “flash” orders exploding into public view, investors are wondering if the rapid-fire dissemination of their investing intentions is costing them money.

The flashes, which exchanges send to specific groups of market participants before routing the orders to the wider market, have been slammed by U.S. lawmakers and probed by regulators. On Thursday, two major exchanges said they would end the controversial service.

If all the bluster conjures up suspicions of “front-running” — trading ahead of market-moving customer orders — it may be because the industry is still buzzing over a clash here in May between NYSE Euronext Executive Vice President Larry Leibowitz and Direct Edge Chief Executive William O’Brien, who debated flashes on an industry panel.

Leibowitz compared flashes offered by Direct Edge, an alternative stock-trading venue, to the roundly despised advanced look at orders New York Stock Exchange floor specialists used to have.

He said Direct Edge’s service created a two-tier market because it “flashed” buy and sell orders to a select group of banks, hedge funds and others, calling into question fair access to public stock prices.

O’Brien, whose firm has grown impressively, partly due to flashes, interrupted Leibowitz, saying flash orders are optional, create liquidity, and in no way resemble the front-running that tarnished the Big Board over the last decade.

In 2004, dozens of NYSE specialists were investigated and several firms were prosecuted for trading ahead of customer orders. That embarrassing investigation came after a late 1990s case in which floor brokers pleaded guilty to front-running.

It’s unlikely that flashes — now offered by three top U.S. stock markets to a far wider pool of participants — have led to the illegal kind of front-running that landed NYSE floor brokers in trouble. But flashes could pave the way for recipients to benefit from peeks at valuable information.

“All information is power in these markets. The question is how much of an advantage is it to see little pieces,” said Larry Harris, professor of finance at the University of Southern California’s Marshall School of Business and author of the market microstructure book “Trading and Exchanges.”

ABSORBING INFORMATION
Exchanges are required to send orders to the venue with the best bid or offer, so traders get the best possible price.

But for years, Direct Edge and the CBOE’s small stock market flashed orders to market makers before sending them elsewhere, giving trading venues one last chance to keep the orders in house if the flash recipients fill the orders at the best national price.

The flashes last for fractions of a second, enough time for high-frequency trading firms and others with lightening-quick computer software to respond — if they choose.

“You can view it all day and you don’t have to trade with it,” said Justin Schack, vice president of market structure analysis at agency brokerage Rosenblatt Securities, which monitors the growth of flashes. “But you can go ahead and use that information to trade in a proprietary fashion that might hurt the person whose order was flashed.”

Richard Repetto, an analyst at Sandler O’Neill who issued a report on the topic Thursday, said of flash recipients, “If they had to interact with it, that would be one thing. But they can simply absorb the information.”

The U.S. Securities and Exchange Commission said this week it is drawing up plans to possibly ban flashes, calling them a concern. Nasdaq OMX’s <NDAQ.O> Nasdaq Stock Market and BATS Exchange launched flashes June 3, but both have now pledged to end the program by next month.

FLASHING, BUT NOT MOVING, MARKETS
Although flashes show the intentions of investors, it’s doubtful most flashed orders are big enough to move markets, disqualifying them from traditional front-running.

The block trades of 10,000 shares or more that past front-runners took advantage of have sharply dwindled this decade, as increasingly electronic markets have forced investors to spread orders among dozens of venues so as to hide their intentions.

“If somebody foolishly flashes a big order and people jump in front of it, well it was their fault for being foolish,” said USC’s Harris. “If the traders themselves are worried about front-running, they won’t use the orders.”

Indeed, if flashing boosted trading costs, flash orders probably wouldn’t have grown from about 1 percent of U.S. trading volume before Nasdaq and BATS started them, to 2.4 percent by the end of June, according to Rosenblatt data.

As well, brokers would be seriously remiss to expose clients’ market-moving intentions in a single order, while those broker-sponsored firms that have direct access to markets are typically sophisticated enough not to tip their hands.

Chris Nagy, managing director of routing strategy at TD Ameritrade Holding Corp, which flashes its orders through Direct Edge and Nasdaq, said flashes improve prices for clients, suggesting meaningful front-running is unlikely.

“Retail investors have not been harmed by flashes or high-frequency trading — they’ve benefited tremendously,” he said.

While Direct Edge has defended flashes, the NYSE has remained a vocal critic.

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