SEC Chair Tells Senator Schumer that Commission Will Ban Flash Trading

Senator Charles Schumer (D-NY) announced that SEC Chair Mary Schapiro has assured him that the Commission plans to ban the practice of flash trading that gives advance knowledge of stock orders to certain traders. Ms. Schapiro said that the ban on flash trading would occur as part of a larger look at dark pools and high-frequency trading. The SEC reaction came in response to a letter Sen. Schumer sent last month saying that the SEC should eliminate the practice or else he would offer legislation to do so. Praising the SEC’s decision, Sen. Schumer, a senior member of the Banking Committee, said that the Commission would stay vigilant against future market innovations that might similarly harm market transparency.

Flash orders allow sophisticated high-frequency traders to gain access to trading information before it is sent out widely to other traders. For a fee, the exchange will “flash” information about buy and sell orders for just a few fractions of a second before the information is made publicly available. These traders, using super-fast computers, can then act on that early information to trade ahead of the pending orders. The practice can influence the pricing of stocks, experts say.

It is also important to make sure that flash orders are not just the tip of an iceberg lurking in the dark reaches of the market, the senator added. While noting that there is a lot of mystery about what goes on in dark pools and in the realm of high-frequency trading, Sen. Schumer was confident that the SEC would be able to separate valid innovation from other practices that give some traders an unfair advantage over others.

In the senator’s view, market integrity is being compromised by the ability of some insiders to view order information before it is available to the entire market and use electronic trading strategies to profit from that information at the expense of other investors.

In his letter to the SEC, Sen. Schumer expressed concerns with regard to special programs offered by exchanges such as NASDAQ and BATS, as well as an electronic trading platform called DirectEdge. Each of these marketplaces have allowed sophisticated high-frequency traders to gain access to trading information before it is sent out widely to other traders. For a fee, the exchange will flash information about buy and sell orders for just a few fractions of a second before the information is made publicly available.

In his statement announcing the SEC’s intention to ban flash trading, the senator said that two major exchanges that offer the service indicated they would go along with a potential ban. Both NASDAQ and the BATS exchange publicly acknowledged that flash orders can pose an inherent threat to market integrity. Meanwhile, DirectEdge has defended the technique as a necessary source of liquidity for exchanges.

While conceding that pre-routing programs can benefit markets by providing additional liquidity, the senator observed that this kind of unfair access seriously compromises the integrity of the markets and creates a two-tiered system under which a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions. If allowed to continue, he warned, these practices will undermine the confidence of ordinary investors, and drive them away from the capital markets.

The SEC has also become increasingly concerned about the post-trade transparency of dark pools, which are electronic trading systems that do not display public quotes. According to James Brigagliano, Co-Acting Director of the Division of Trading and Markets, this lack of post-trade transparency can make it difficult for the public to assess dark pool trading volume and evaluate which ones may have liquidity in particular stocks. In recent remarks at a SIFMA seminar on market structure, he also examined the potential effect of dark pools on the public price discovery function.

Public quote streams are distributed by central processors that act on behalf of all the SROs in making market information widely available to the public. Over the last year, dark pools, which do not display public quotes, appear to have increased their percentage share of total trading volume in US-listed stocks. But the SEC official noted that there is very little reliable public information on dark pool trading activity. He said that this lack of public information illustrates a transparency concern that warrants attention. Dark pools report their trades to the consolidated public trade streams, but their trades are identified merely as non-exchange, or OTC, trades. The public trade reports do not identify whether an OTC trade was reported by a dark pool and, if so, the identity of the dark pool.