You Decide

By Edgar Ortega, Jesse Westbrook and Eric Martin

Aug. 5 (Bloomberg) -- The U.S. Securities and Exchange Commission’s move to ban so-called flash orders may help NYSE Euronext take back market share of U.S. stock trading at the expense of three-year-old rival Direct Edge Holdings LLC.

Senator Charles Schumer said yesterday the SEC will seek to stop the practice in which some brokers get a split-second advantage in viewing requests to buy and sell stock, after discussing the issue with Chairman Mary Schapiro. NYSE Euronext, the only one of the top four U.S. exchanges that doesn’t use flash orders, has seen its portion of the nation’s share trading slip to 30.3 percent in the second quarter from 35.5 percent a year earlier, while Direct Edge’s doubled since November.

“The big existing exchanges are going to be benefiting because the pendulum is swinging back in that direction in the area of transparency,” said Thomas Caldwell, who manages about $1 billion, including NYSE shares, as chairman of Caldwell Financial Ltd. and president of Urbana Corp. in Toronto.

Flash orders grew to 2.4 percent of the shares traded in the U.S. in June, three years after the practice began as a way of increasing the odds an order would be filled, according to data compiled by New York brokerage Rosenblatt Securities Inc. Schumer said the delay in routing transactions to other exchanges makes it easier for brokerages with the fastest computers to get an edge calculating demand for a stock.

Boston Exchange

The SEC under Chairman William Donaldson first approved a flash-trading system in 2004 for the Boston Options Exchange. Since then, Nasdaq OMX Group Inc., Bats Global Markets and the CBOE Stock Exchange have introduced programs that hold orders before publishing them on rival platforms.

Direct Edge, based in Jersey City, New Jersey, used its early lead in flash trading to take business from rivals. The company is the fastest-growing equity market in the U.S., helped by its three-year-old Enhanced Liquidity Provider program, which handles the most flash trades.

Even excluding flash orders, Direct Edge matched 11.2 percent of U.S. stock trades in July, making it the third- largest U.S. equity market by volume, according to data compiled by Bloomberg. That may help fuel growth if regulators start a broader review of off-exchange trading, Chief Executive Officer William O’Brien said in an interview yesterday.

“It’s almost impossible to assess the impact on any of us of reforms that don’t exist yet,” O’Brien said. “We feel quite optimistic that regardless of how this debate goes forward, we are in a good position to continue the market share growth that we have experienced in the last couple of years.”

Bad Policy

NYSE Spokesman Ray Pellecchia said in an interview yesterday that flash trading “is not a good policy for investors.” NYSE Euronext, operator of the biggest stock market, added 2.4 percent to $27.40 in New York yesterday. Nasdaq shares declined 0.3 percent to $21.39.

“In the short-term, most of the negative impact will fall on a player like Direct Edge,” said Sang Lee, managing partner at financial-services consultant Aite Group LLC in Boston. “If they decide to ban this altogether, there would be an impact.”

The benefit from a ban to any other exchange may be limited because the orders don’t represent a big enough slice of industry revenue, said Ed Ditmire, an analyst at Fox-Pitt Kelton Cochran Caronia Waller in New York.

“Anecdotally, the NYSE would have the most to gain if there were some market share shift due to flash orders being banned,” Ditmire said. “Keep in mind that Nasdaq and NYSE get about 10 percent of their revenue from U.S. equity trading, so even something that led to noticeable market-share shifts might not move the dial on the overall company very much.”

Trading Inequity

Schapiro said yesterday she asked her staff to draft rules that can “eliminate the inequity” that flash orders cause as part of a broader review of trading in dark pools, which are broker-owned markets that don’t display quotes to the public. Any proposal would require approval from SEC commissioners and public comment. Schumer, a New York Democrat, urged the SEC in a July 24 letter to halt flash orders, saying he would propose legislation barring them if the agency didn’t act.

The plan may be a sign regulators are moving to stricter oversight of so-called high-frequency trading, in which brokerages using advanced computers execute thousands of transactions in a second. Those strategies may account for 70 percent of share volume in the U.S., according to Patrick O’Shaughnessy, an analyst for Raymond James & Associates Inc.

While flash orders make up a small fraction of high-speed trading, they have drawn the most criticism from investors and traders. Goldman Sachs Group Inc. released a statement yesterday in light of the “complex landscape” surrounding high-frequency trading, saying the strategy accounted for less than 1 percent of its revenue and that it doesn’t use flash programs in executing client agency orders.

Other Platforms

The Nasdaq and Bats gained approval this year for flash orders after the SEC said they complied with federal rules and should be filed as so-called non-controversial proposals. The agency had until June 29 to reverse its decision for Bats as part of its normal review of the flash-order plan, regulatory filings show. The deadline for Bats passed July 28.

“When practices and rules have been legally approved for one market participant and another competitor comes in wanting to do a similar activity, we think it’s important to have a level playing field and not play favorites,” James Brigagliano, acting co-head of the SEC division responsible for oversight of exchanges, said in an interview. “That said, market developments may cause us to seek changes in the rules across all markets.”

Industrywide Ban

Bats and Nasdaq said last week they support an industrywide ban on flash orders. Bats Chief Executive Officer Joe Ratterman urged the SEC last month to review 2006 rules that require exchange to publish their best bids and offers, while Nasdaq’s Robert Greifeld called for an examination of 1998 rules governing alternative trading systems such as Direct Edge.

SEC rulemaking is usually a two-step process. The agency’s staff proposes a regulation, and commissioners vote to solicit public feedback for up to 90 days. Once the comment period ends, commissioners vote on whether to make the rule binding. The SEC can speed up the process by issuing temporary rules.

That may result in less than an outright ban of flash orders, said Jack Sylvia, the Boston-based co-chair of the Securities Litigation Practice at law firm Mintz Levin Cohn Ferris Glovsky & Popeo PC.

Plusses, Minuses

“Schapiro said she’s looking to obviate any inequities from flash trading, and I’m not sure that’s the same as saying we need to ban flash trading altogether,” Sylvia said in an interview yesterday. “If the case is made that there is nothing beneficial to market stability and efficiency from flash orders, I could see the case being made for the practice to be banned. But I suspect that there are plusses and minuses here.”

Flash systems trace their roots as far back as 1978 to efforts by exchanges to electronically replicate how a trader might yell an order to floor brokers before entering it into the system that displays all bids and offers. Markets have evolved since the days of floor brokers’ dominance, with computer algorithms now buying and selling shares 1,000 times faster than the blink of an eye.

“This is a relatively old concept. However, the electronification of it makes it more dangerous than it used to be,” said Sean O’Malley, a former lawyer at the SEC’s division of trading and markets who is now a partner at Goodwin Procter LLP in New York. “Computer-based trading is going to be able to do things in a split second that no human could have done. That’s something that the SEC probably hadn’t thought about as much until this year.”