'Exchanges' anonymous trading sets off alarms'

Recently I posted here and here about NYSE Euronext's objections to practices by some exchanges to "flash" order information in advance to a select group of market participants. Today Reuters reports news of letters of opposition from GETCO and SIFMA, and Securities Industry News reports on letters from Charles Schwab (opposing) and TD Ameritrade (in favor).

Excerpt from Reuters:

At issue are so called "flash" orders -- buy and sell orders the Nasdaq Stock Market and BATS Exchange this month began sending to a private group of select market participants before routing them to rival venues. The service closely mirrors one long offered by fast-growing alternative venue Direct Edge. ...

Flashes, although not a top priority for regulators, are unlikely to survive completely unfettered, given the financial crisis is ushering in sweeping changes intended to make markets more transparent and participants more accountable.

"One of the things we should have learned in the last 24 to 36 months is that innovation in the financial services industry is not necessarily in the best interest of the average investor," said Richard Gates, portfolio manager of TFS Capital's $620 million market mutual fund. ...

Rather than follow suit, New York Stock Exchange parent NYSE Euronext urged the SEC to halt the programs on grounds they harm markets and investors.

In another letter to the SEC, Direct Edge defended ELP, FLASH and BOLT as innovative and beneficial to customers who pay lower trading fees and enjoy better liquidity -- arguments that were later countered by letters from market-maker GETCO and financial industry group SIFMA.

SIFMA charged that Nasdaq did not provide enough time for member firms to make necessary changes in order routing systems, nor enough time to debate the controversial issues it raised, such as price transparency and the creation of a "two-tiered market" that could hurt investor confidence.

"Exchanges should not be permitted to put firms in the difficult position of potentially being out of regulatory compliance in order to advance their own commercial, competitive agendas," SIFMA said in its June 4 letter.

"You get the feeling when trading that you're not seeing the whole picture," said Bernie McSherry, senior vice president at institutional broker Cuttone & Co.

"You've got lots of hidden liquidity, you've got orders that are being exposed preferentially to some participants and not others, and I think that just works against an efficient market," he said. "It's not a good development." ...

Excerpt from Securities Industry News:

... "We're concerned about these programs on a couple of levels," says Jeff Brown, head of legislative and regulatory affairs at San Francisco's Charles Schwab.

Brown says accessing an exchange's private quote-data feeds, in order to make use of the pre-routing displays, will increase costs. Also, Brown says, the private feeds, which provide more detailed quote information, could give trading firms an advantage over retail and other investors relying on the consolidated public quote stream known as SIP.

"Investors should be allowed to know all the information available at any given moment to make reasonable decisions," Brown says, adding, "That's the whole reason we have consolidated quote information."

Meanwhile, TD Ameritrade has used electronic communication network (ECN) Direct Edge's Electronic Liquidity Provider (ELP) program nearly since its inception more than three years ago. Chris Nagy, managing director of order routing, sales and strategy at the Omaha-based firm, says the ELP program has given retail investors access to dark (or un-displayed) liquidity and the improved prices that result. That is a capability that previously has been available mainly to institutional investors. ...

Getco, a major electronic trading firm based in Chicago, notes in its comment letter to the SEC that firms can execute thousands of orders in multiple symbols in less than a second, giving pre-display program participants an edge over investors relying on the slower public quote stream.

Getco says that could increasingly result in a two-tiered market that conflicts with notions of fairness espoused by rules such as Reg NMS and makes the market less efficient.

"If [pre-display] order functionality proliferates among all the equities exchanges, it would serve as a disincentive for market participants to display liquidity at better prices because they will increasingly not be rewarded with an execution, even as they provide valuable information to the market as a whole through the public posting of orders," note Stephen Schuler and Daniel Tierney, each managing members at Getco, in their comment letter.

Brown notes that specialists on the New York Stock Exchange used to be roundly criticized for taking a "first look" at orders arriving on the floor. "If you do it fast and electronically, it's OK, and, if humans do it on the NYSE floor, they get prosecuted," Brown says. ...