Rarely, if ever, does the arcane world of electronic equities trading preoccupy the glamorous hosts of US network television. This summer, however, the little-known and understood enclave of the US financial markets erupted into the public consciousness in an unprecedented furore that promises to bring about the most dramatic structural changes to the US cash equities markets since the introduction of Regulation National Market System (Reg NMS) in 2005. At the heart of the row stands the pre-routing program or so-called 'flash' order, a trading order type that even amid seasoned trading experts proves something of a specialism.
Taken at face value, the commotion principally concerns regulation. Under Reg NMS, US trading venues are obliged to immediately route orders that they cannot fill at the best national bid or offer (NBBO) on to an away marketplace that is displaying the NBBO. Pre-routing programs attempt to circumvent this obligation: by briefly routing an order that cannot be filled at the NBBO away from the displayed market and 'flashing' it to off-exchange liquidity pools, a trading venue increases its likelihood of filling an order at the NBBO and attracting further liquidity to its marketplace.
A particular type of flash order operated by Direct Edge, a New Jersey-based electronic communications network (ECN), has raised the ire of the US exchanges which have campaigned vigorously for its elimination. Some six months since flash first struck the industry headlines and, not only is the order type heading for the scrapheap, but the US Securities and Exchange Commission (SEC) is now casting a circumspect eye across a slew of market practices. And all for an order type that accounts for less than 3% of trading volumes on any given day.
The various merits and shortcomings of the flash order type have been discussed, at least in the media, to the point of exhaustion. But throughout the controversy, several issues have yet to be fully explained: why and how did this sub-second tool of US cash equities markets become so controversial? What role have the exchanges played in bringing the issue to the attention of the regulators? What is their true motivation and why did the SEC act when it did?
William O'Brien, CEO of Direct Edge
Taking the edge
Although Direct Edge has largely but not single-handedly pioneered the flash order type, William O'Brien, the company's CEO, is reluctant to characterise Direct Edge as the subject of the industry controversy. The many and varied accusations levelled at flash are "not necessarily directed at our company or the way in which we use it", he says.
This view, while undoubtedly correct, downplays the central role that the industry's rising star has played in the flash drama. Since its inception in 2005, the ECN has enjoyed phenomenal success which accelerated late last year: between October 2008 and the end of April this year, Direct Edge's market share surged by some 70%. Although measuring market share is itself a controversial subject, the upstart is widely recognised to have surpassed chief rival BATS Exchange in March to become the third largest execution venue in the US, with some 12.5% of the US daily matched market share. BATS Exchange, another ambitious start-up founded in 2005, boasts about 9.5% to 10%.
Much of Direct Edge's success has been achieved at the expense of exchange operators NYSE Euronext and Nasdaq OMX, the two giant, blue-blooded incumbents that once enjoyed an unshakeable duopoly in the US markets. Between July 2007 and July 2009, Nasdaq and NYSE's combined market share fell from 71.3% to 50% in a steady downward trajectory that has been matched by a similar long-term decline in each institution's share price. A fierce, technologically driven four-way battle has unfolded in which innovative order types and pricing models capable of accruing ever more liquidity serve as critical competitive differentiators.
Direct Edge's ELP (enhanced liquidity provider) program has proved one such differentiator. Introduced in spring 2006, ELP allows subscribers integrated access to multiple sources of dark liquidity: a subscriber, for example a proprietary trading firm, sends an order to the Direct Edge displayed market to look for a match at the NBBO. If a match is unavailable on the lit market, Direct Edge does not immediately route on the order. Instead, it flashes its network of anonymous electronic liquidity providers - comprised of about 25 broker-dealers - to offer these parties a brief opportunity to match the order. In the event the order remains unfilled, it is then routed on to whichever market is displaying the NBBO. The entire process takes place within the blink of an eye.
By offering its ELP partners a sub-second glimpse of orders that are to be routed on, Direct Edge increases the likelihood of filling the order while simultaneously depriving its competitors of order flow they might otherwise have received. It also allows a subscriber access to multiple fragmented pools of dark liquidity through a single point of entry, while potentially offering its users an appreciable price improvement and the chance to avoid the fees associated with executing on an exchange.
The momentum effect
The ELP flash order program has consequently proved uniquely popular as evidenced by its spectacular growth: between late April and July last year, for example, Direct Edge saw the volume of shares executed through the ELP program double. The scheme's success did not escape the notice of Direct Edge's three key competitors, least of all Joe Ratterman, CEO of BATS Exchange. Mr Ratterman's view, which he has held since early 2008, is that the functionality of ELP does not "align itself with what the spirit of Reg NMS is trying to achieve", a spirit that ECNs should also uphold, he says.
In a BATS newsletter published on July 30, the exchange chief moved to fully articulate these concerns: the first and most widely repeated contention he put forward is the potential for flash functionality to create a "two-tiered" marketplace in which the best quotations from specific markets are made available to a select group of market participants.
The integrity of the consolidated tape system (CTS), in which all transaction data is recorded and used as a critical benchmark, could also be damaged by the proliferation of the flash order type, he noted. It also remains unclear how the use of flash might be reconciled with a firm's obligation to seek best execution. What's more, he went on, should flash orders be allowed to populate the marketplace and marginalise the usefulness of the CTS, brokers may be saddled with a costly requirement to subscribe to a slew of direct data feeds in order to access all available quotes.
Nasdaq, meanwhile, has complained that, in addition to reducing market transparency, flashes deprive customers posting orders on lit markets the chance to find a match. By extension, Mr Ratterman contends, the repeated inability to find a match in the lit markets may discourage investors from displaying their orders, thereby impeding the critical process of price discovery.
Mr O'Brien is quite clear in his defence: Direct Edge's ELP program is an innovation that provides a useful bridge between the light market and the ever-increasing pools of dark liquidity. "We have clearly been an innovator in capitalising on some trends in the market structure, which have been brought about through automation and the opportunities it could create for us to build next-generation solutions for our customers," he says.
In a bid to fuel the controversy and fill column space, however, several commentators and pundits have complained bitterly that flashes expose information that may allow traders to 'front-run' orders. The widespread perception, meanwhile, that flash orders are the preserve of hyper-sophisticated high-frequency traders has further cemented the misguided notion that the lay retail investor is in turn being cheated.
Amid a climate of intense investor scepticism, the charges against flash have spilt over into the mainstream media, triggering a wave of popular anxiety that has been vigorously championed by New York senator Charles Schumer and Delaware senator Ted Kaufman. "Flash has certainly been used by politicians to highlight the potential inequities between Wall Street and Main Street," says Scott DePetris, global head of client accounts at Portware, a provider of algorithmic-trading software.
In August, the SEC indicated its intention to investigate and ban the flash order type as part of a broader exploration of dark liquidity. But it did not stop there. As the outcry gathered momentum, the regulator expanded its investigation to cover a host of established Wall Street practices, including high-frequency trading, co-location - whereby trading firms host their servers next to those of the exchange - as well as the mechanisms by which some parties gain market access and the so-called 'maker-taker' exchange-pricing model.
Joe Ratterman, CEO of BATS Exchange
Long road to the SEC
But the road to the SEC was not nearly as simple or straightforward as it appeared at the time. It is clear that Direct Edge's competitors have long resented the ELP program and have privately argued for its elimination. BATS, for example, complained directly to the SEC regarding the issue prior to May this year but the SEC, already over-burdened with a lengthy to-do list, was not responsive, says Mr Ratterman. It was only when private disquiet boiled over into an unseemly and now infamous public spat between Mr O'Brien and NYSE Euronext's group executive vice-president Larry Leibowitz at a conference in mid-May, however, that the issue hit the industry headlines and the row began to gather pace.
This made it all the more confusing when just a few weeks later, in the week commencing June 1, both BATS and Nasdaq went live with their own version of the much-maligned flash functionality in the form of the BATS Optional Liquidity Technology (BOLT) and Nasdaq's Routable Flash Order and INET-Only Flash order types. In contrast to Direct Edge, however, which flashes orders on request to a network of subscribers, BATS issued the flash via its direct feed to all its members. This momentarily created a virtually 'locked' market whereby bids and offers disseminated via BATS' feed equalled bids and offers being disseminated over the central securities information processor.
Two brokers report that this aspect of the functionality confused their systems, generating considerable controversy among the broker community. "They didn't really give the industry much notice that they were going to change their default behaviour," says a director of execution services at a major investment bank. "At lot of people were very surprised that their orders were being flashed without their knowledge. That's really what caused the whole controversy." The move prompted NYSE Euronext, the Securities Industry and Financial Markets Association and Getco, one of the world's largest market-makers, to issue outraged letters to the SEC calling for the regulator to intervene. When the SEC indicated in August that it planned to investigate the flash functionality, BATS and Nasdaq announced that they would both terminate their flash orders, which they both did on September 1.
For many market-watchers it seems little short of perverse, however, that two exchanges so publicly condemning of flash functionality would introduce it in their own markets. Furthermore, developing a new order type is not an overnight affair. It can take months for an exchange to roll out new functionality. This makes the proximity of the BATS and Nasdaq flash launches seem highly coincidental, prompting some market-watchers to speculate that the exchanges coordinated their efforts. Certainly, the move to pull the flash order resulted from an appeal on the part of BATS to all the exchanges, including Direct Edge, to eliminate flash functionality.
Mr Ratterman denies that BATS and Nasdaq coordinated their efforts to introduce flash. But when Direct Edge began positioning itself to apply for exchange status in the latter half of 2008, the situation regained renewed urgency, says Mr Ratterman. "That was when a line in the sand was crossed," he says. "I believe the executives at Nasdaq saw the same thing that we did... so each started raising concerns... independently."
In the case of BATS it is now clear that Mr Ratterman never wanted to launch BOLT at all. By filing the BOLT application with the SEC, in which BATS repeatedly outlines the potential to virtually, if momentarily, lock the market, Mr Ratterman hoped to prompt an immediate SEC investigation into all flash orders. "We were torn between knowing what we thought was good for the markets versus what was going to be allowed by the regulators," says Mr Ratterman. "If it was going to be allowed, we didn't want to be at a competitive disadvantage and we thought that we might have more influence over the situation if we were actively engaged in using it while, at the same time, continuing to campaign for reasons why it shouldn't be allowed." But the SEC found the application to be legal and both exchanges were allowed to roll out the new functionality.
If BATS' actions have been confusing for the marketplace, at least its public statements on the issue have been consistent. Nasdaq, however, appears to be confused. In an SEC filing, the exchange writes that its flash orders are consistent with the statutory requirement to "remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest". In July, Brian Hyndman, senior vice-president for Nasdaq transaction services, also told US industry journal Traders Magazine that the introduction of flash would benefit its customers. But in his testimony to the US Senate subcommittee hearing on market structure issues on October 28, Frank Hatheway, Nasdaq's chief economist, said the exchange had had "reservations" regarding how flash would affect the market, a statement which followed other public attacks on flash issued by Nasdaq in August after Senator Schumer decried the practice.
In this respect, the actions of the exchanges have not been transparent and, in some instances, difficult to reconcile with their actions, says Mr O'Brien. "There has not been a lot of accountability with respect to statements that these organisations have made, what they believe and what they are doing." When contacted on this issue a Nasdaq spokesperson said: "Nasdaq OMX has been consistent and clear in its views with regard to flash order types."
Larry Tabb, CEO of Wall Street analyst firm TABB Group
Competition not regulation
That Nasdaq has struggled to craft a consistent public message on the issue of flash may say more about the competitive environment in which the exchange finds itself than flash or the market structure at large. Indeed, many market participants, Mr O'Brien chief among them, believe that the row regarding the regulatory aspects of flash is really about brutal competition. "Competitive issues really shaped the regulatory advocacy of a lot of our competitors," says Mr O'Brien.
The outcome of the SEC filings poses a key question: if both BATS and Nasdaq were legally able to deploy the same functionality as Direct Edge, why did they continue to campaign for a regulatory review?
For competitors wishing to stifle Direct Edge's rapid growth, the ELP program is a natural target. In late August 2009, market-watchers speculated that the program accounted for about 5% of the ECN's overall trading volumes but for some 25% of its profits. Mr O'Brien is cagey regarding the importance of the ELP program to the profitability of the privately owned company as a whole but he confirms that historically the ELP program has accounted "for a bigger percentage of our profitability than the percentage of our volume would indicate". In July 2008, some time before the row broke out, he was, however, more vocal on the issue, telling Reuters that the program had offered Direct Edge a "substantial advantage in the marketplace".
Both BATS and Nasdaq have said that they introduced their versions of flash reluctantly to prevent being at a competitive disadvantage while simultaneously, at least in the case of BATS, calling for a regulatory review. George Hessler, executive vice-president at Lime Brokerage, a New York-based high-frequency broker which was also an early backer of BATS, reports that BOLT "quickly gained acceptance among certain participants". In fact, having matched some 84.4 million shares via BOLT in its first day of trading, BATS' new order type was well on its way to matching Direct Edge's ELP volumes, despite the initial confusion. This being the case, it would appear that both BATS and Nasdaq deprived themselves of what could potentially prove a useful competitive tool in the broader interests of protecting the prevailing market structure.
But as Larry Tabb, CEO of Wall Street analyst firm TABB Group, points out, this presupposes that either exchange could wield the tool nearly as effectively and profitably as Direct Edge. Under the popular 'maker-taker' model, exchanges pay a rebate to liquidity providers. Direct Edge, however, has changed this structure: instead of rebating its ELP partners, Direct Edge charges them a routing fee every time they execute against a flashed order. This revenue is used to subsidise aggressively priced rebates on Direct Edge's lit market. "Being able to pay more money to firms posting liquidity brought more liquidity into its market," says Mr Tabb. "This created a business model that the other guys couldn't replicate very easily and enabled it to overtake BATS."
The flash order type also tends to favour the newer marketplaces because, having a smaller market share, they are less likely to display the NBBO, says Jamil Nazarali, managing director and global head of the electronic trading group at retail brokerage Knight, a founder and ongoing stakeholder in Direct Edge. "If the smaller exchange isn't at the NBBO, flashing it means that it can still fill the order at the best price without having to send it to the big guy. But if you're the big guy, the chances are higher that you will have the best price, so there is much less advantage in flashing the order." This suggests that Nasdaq, as a far larger market, would be unable to enjoy the same competitive benefits through its own use of flash as that of Direct Edge. Mr Hatheway seemed to imply this when he told the Senate subcommittee that its own flash order type "never became a particularly material part of our business". In the Nasdaq Group OMX third-quarter earnings call in early November, however, Nasdaq CEO Bob Greifeld went further, telling analysts: "Clearly the elimination of flash orders is positive for us."
Had Direct Edge's counterparts believed they could accrue the same competitive benefits from flash functionality as the New Jersey-based ECN then they might have been less fussy regarding its regulatory legitimacy - particularly after the SEC found the Nasdaq and BATS filings to be legal and the issue to be of limited regulatory interest initially. But if they had more to gain through the wholesale elimination of flash than through its adoption on their own markets then pursuing the regulatory angle may have made more commercial sense.
Mr Ratterman does not deny that the complaint against flash is a competitive one but this does not make the regulatory point any less relevant, he says. "If one competitor is using a set of rules that no one else is using and they're getting an advantage then of course all the other competitors on the field are going to complain."
Politics and personality
None of which suggests, however, that NYSE Euronext has played any lesser role in the controversy. According to some, the exchange has been the most influential player of all. Most market-watchers and even competitors shy away from publicly accusing NYSE of lobbying the SEC via political channels. But the exchange has made no secret of its intention to court and exploit political favour in order to gain a commercial advantage.
One of the most striking testimonies to its political strategy came from the mouth of its chief executive, Duncan Niederauer, during at a New York conference hosted by investment bank Sandler O'Neill and Partners in early June.
In his publicly available presentation on the company's commercial strategy, the exchange chief said of Direct Edge's ELP program and flash order types more broadly: "We have started to play offence on that and we're going to keep playing offence on that." Regarding the wider SEC investigation in to the advanced trading system (ATS) community and dark pools, he further noted: "Only good things can come out of that for us if [the SEC] decides to make it more costly to run an ATS or it spreads the cost of regulation - whatever it might be. Suffice to say, we're going to play a lot of offence in Washington."
This offensive has evidently paid off. The timeline of events suggests that, while Nasdaq and BATS' flash orders raised the ire of the market, the SEC did not move to act until senators Schumer and Kaufman took up the cause. On July 27, Mr Schumer, a long-time Wall Street activist, wrote to SEC chairman Mary Schapiro specifically requesting that she move to ban flash orders adding that, should she fail to do so, he would act to legislate against them. Exactly a week later, the SEC announced its intention to implement a ban but it was Mr Schumer's office, not the SEC, which broke the news of the imminent clampdown following a phone call the senator made to Ms Schapiro to push her on the subject.
The perception that the political establishment is now driving the SEC agenda is widespread: after all, if the SEC really believes flash trades are worth prohibiting, why did it fail to conclude as much when the issue was brought to its attention some months earlier?
NYSE, which declined to comment, is attempting to serve the best interests of its shareholders through a political campaign while simultaneously claiming to advance the good of the market. But this is a tricky juggling act. Many market-watchers question whether the complex US equities markets can possibility benefit if politicians unfamiliar with the complexities of the micro-market structure are encouraged to direct regulatory change. "The SEC seems to have adopted Senator Schumer's letter. To me, that appeared to be political and made all kinds of statements with no data corroboration or even opinion from experts in the field," says Keith Ross, the CEO of alternative trading system PDQ, and formerly the CEO of Getco. "I don't question his good intention but I think the key element here is that the SEC needs to be the one creating the rules after serious study and data analysis."
Most market-watchers agree that it is legitimate for the SEC to take a fresh look at the marketplace given its rapid evolution in recent years. But there is a strong fear among many participants that the regulator will be politically pressurised into making damaging changes. "The conversation is being driven by people who do not understand market structure. By simplifying explanations of certain standard market practices there is a danger that the efficient market structure that has been created might be harmed," says Mr Hessler. This would be a lamentable outcome for what many believe to be the most transparent, efficient, and fair marketplace in the world.
