The Securities and Exchange Commission in the US has proposed a ban on “flash orders”, a practice it feels gives high-frequency trading companies an unfair advantage over other traders.
What are flash orders?
Some US exchanges flash quotes to a set of traders a few milliseconds before the quotes are flashed for the entire market, in exchange for a fee.
Since anyone can subscribe to these special feeds, some market participants and experts feel that it isn’t wrong to allow flash orders.
Besides, flash orders don’t benefit only high-frequency traders (HFTs), but also ordinary investors.
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Consider, for instance, a stock that is quoting at a bid-offer of 100/105 on exchange X and an ordinary retail or institutional investor who comes into the system with an offer of 102.5. Since the best bid is at 100, the probability of the order getting filled in immediately at exchange X wouldn’t be high.
Meanwhile, if prices move to say 95/100, the investor would end up with much lower-than-expected realization. Now, most US exchanges are linked to electronic communication networks (ECNs), a type of computer system that facilitates trading of financial products outside of stock exchanges. To enable best execution, exchanges allow routing out orders to such ECNs if an investor’s order cannot be immediately filled in at the exchange.
Coming back to the example, if the order is not immediately filled in at exchange X and the best bid at an ECN is 102.5, the order will be routed to the ECN. For this, the exchange will charge the investor a routing fee.
While investors give utmost importance to their orders being matched, they would still like to avoid the routing fee. Here’s where flash orders help.
Their quote will be first flashed to those who have subscribed to the flash orders feed from the exchange. If a buyer within the system ends up filling that order, the investor can avoid the route-out fee. Of course, all this happens at lightning speed because of advanced trading technology. Many investors like this feature because it enables better execution at the lowest possible cost.
One of the largest retail brokers in the US, TD Ameritrade, has said that flash trades have enabled to offer better execution for its customers.
The problem arises when HFTs who receive the flash orders engage in front-running those orders. News reports suggest that in some cases these flash quotes did result in front-running, which is an illegal activity. If that is the case and there are some investors who don’t like their orders being “peeked” at before they are flashed to the entire market, one solution could be to turn off the flash function on their terminal before an order is entered.
This would minimize the number of flash trades in the system, which HFTs could take advantage of. A ban of flash orders may not necessarily be the best solution.
The bigger problem with the flash orders debate is that it has been clubbed with the broad spectrum of high-frequency trading. Only a small proportion of an HFT’s trading strategies would centre, if at all, around using flash orders. A large number of strategies are based on mispricing in the markets or a temporary deviation from historical trends, which such traders seek to benefit from.
Regrettably, flash orders and high-frequency trading have been talked about synonymously by some sections of the US press.
It would be unfortunate if the ban on flash orders is the first step among a slew of measures to slow down HFTs.
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