Stocks are normally traded on either exchanges or alternative trading systems (ATS). Orders to buy or sell are submitted at either the market (prevailing) price or at some specified limit price. Once an order is submitted, an automatic matching process occurs – the order is paired to one or more standing orders, or waits for a satisfactory incoming order. Since exchanges and ATS are linked in a national market system (NMS), orders may be paired with orders from other locations. These orders are publicly announced on the exchange’s ticker, and thus are a source of supply/demand information to all market participants.
Flash trades are different – for a fee, before an order is sent from a trading venue (an exchange or ATS) to the NMS, it is briefly revealed (flashed) about 30 milliseconds in advance. Why? So that a trader at the local venue can have first shot at matching the best bid or ask. In this way, the local trader can capture the order before it is submitted to the NMS. This results in a flash trade. This practice, while once popular at the New York Stock Exchange, has recently been discontinued there – NYSE market specialists (specially-designated dealers) no longer benefit from an advanced peek at orders. Instead, all NYSE participants get equal access to incoming trade order information. It explained that they forbade the practice because it wanted to level the playing field for all traders at the exchange.
However, flash trades play an important role at some other venues, especially ATS that compete with exchanges for order flow. They utilize flash trades to draw volume away from the larger exchanges, and through trading fees realize increased revenue.
Flash trading raises public policy issues, since it gives special privileges – earlier access to order flow information – to a narrow market segment at the expense of the overall market. This sort of favoritism at its face seems to run counter to public policy and market efficiency. Market makers are less likely to post quotes without securing a trading priority, which tends to depress liquidity and the orderly operation of the market. Another controversial aspect is that flash trading only benefits computer-driven trades, such as high-frequency trading systems, because the sneak-preview afforded by flash trading can only be exploited by a high-speed computer. Some observers predict a future where the financial markets consist solely of computers trading with other computers, while humans sit on the sidelines and cheerlead. One wonders what the source of job satisfaction will be under this scenario.
Flash trading reminds some people of the earlier, illegal practice of front-running – brokers trading for their own accounts with knowledge of their customers’ pending orders. For instance, if a broker noticed buying pressure reflected in his customers’ pending bids, he could buy shares before prices rose, and then sell out at the higher price once he placed his customer’s orders. A legal variant is called tailgating, in which a broker first places customer orders, and then trades the same stocks for his own account.
Currently, many venues have voluntarily suspended flash trading due to unfavorable comments from regulators and market participants, but without specific rules outlawing the practice, flash trading may return at any time, and may spread globally to less-regulated markets.
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