SEC Proposes Ban on Flash Orders

SEC Chairman Mary Schapiro said at a meeting in Washington that flash orders can produce market inequities.
SEC Chairman Mary Schapiro said at a meeting in Washington that flash orders can produce market inequities. (By Brendan Hoffman -- Bloomberg News)
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By Zachary A. Goldfarb
Washington Post Staff Writer
Friday, September 18, 2009

Federal regulators turned their attention on Thursday to the fast-paced and sometimes opaque electronic trading systems that dominate financial markets, proposing to ban a type of trading that critics contend gives hedge funds and other financial firms an unfair advantage over individual investors.

The Securities and Exchange Commission released a proposal to ban so-called flash orders, which allow a select group of traders to see requests to buy and sell stocks and other securities a split second before the rest of the market.

Regulators worry that traders with the technical savvy and clout to gain access to flash orders will have a leg up, potentially buying or selling securities at prices better than what the market is offering other investors.

"Flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities," said SEC Chairman Mary L. Schapiro. "These flash orders provide a momentary head start in the trading arena that can produce inequities in the markets."

The proposal to ban flash orders is part of a broader review at the SEC into how technology has changed the overall structure of the financial markets, including exchanges and other electronic trading systems.

Some investor advocates, regulators and lawmakers worry that major Wall Street firms are leveraging their access to powerful technology, loopholes in regulation and even geography to make fast trades that book large profits in ways ordinary investors can't.

Critics of these techniques have urged the SEC to examine another strategy called high-frequency trading, in which powerful computers make fast trades based on patterns that only computers can see. The SEC is also looking at so-called dark pools, which allow traders to buy and sell big positions without disclosing ahead of time what they're looking to trade. Also generating concern is co-location, a practice in which firms install their trading servers physically next to servers operated by stock exchanges to create a millisecond advantage over competitors in other countries.

Most on Wall Street say these practices benefit investors by greasing the wheels of the markets. For example, high-frequency traders are often the only ones willing to buy or sell large positions in stocks at any given time. Some who support the ban on flash orders worry that the SEC now may move to clamp down on other practices they consider beneficial.

"There's a real danger that the criticism of flash trading could lead to a desire to rein in high-frequency trading in general. And that could have some bad unintended consequences," said Justin Schack, vice president of market structure analysis at Rosenblatt Securities. "Anything that curtails the ability of high-frequency traders to do what they do today" would raise prices for investors.

According to research by Rosenblatt Securities, at least half of all U.S. stock trades are executed through high-frequency trading. In July, flash orders represented 2.8 percent of U.S. stock trading. Dark pools accounted for 8.5 percent.

The drive to crack down on flash orders has been pushed by several lawmakers, including Sens. Charles E. Schumer (D-N.Y.) and Ted Kaufman (D-Del.).

"The SEC has done what we asked for," Schumer said Thursday.

Kaufman, however, pushed for more.

"Now the SEC must examine the rest of the iceberg," he said. "For investors to have confidence, the SEC must ensure that high-frequency trading, dark pools, potential conflicts of interest and other market structure issues are not undermining the interests of long-term investors."

The SEC also took up Thursday proposals to tighten the reins on credit-rating agencies. These federally recognized companies, including Standard & Poor's, Moody's Investors Service, Fitch Ratings and others, give grades to securities. The companies gave high grades to many securities that turned out to be toxic during the credit bubble.

Among other things, the SEC on Thursday proposed new rules that would require more disclosure about the credit-rating process and asked for public comment on whether the SEC should allow agencies to be sued when their ratings are relied on for investment decisions that later go bad.

To take effect, the new rules would require a 60-day period of public comment and a vote from three of the agency's five commissioners.

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